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Q&A 41Correcting Plan Defects Q&ACorrecting Improper Return of Excess Contributions (Part 4) QUESTION 41: In Q&As 38, 39 and 40, we have discussed the following reader question: "A 401(k) plan failed the ADP test in 1994, and excess contributions were distributed in 1995 to some of the participants believed to be highly compensated employees (HCEs). However, the prior administrator incorrectly determined the HCEs, so that the wrong amounts were distributed to the wrong people. The plan has 19 HCEs and 188 non-HCEs. The plan paid corrective distributions to six of the HCEs, which were larger than they should have received, and to two non-HCEs. Three HCEs who should have received distributions did not. How can we correct these problems?" ANSWER: There are three qualification defects in this situation: the ADP failure in 1994; the excessive distribution to six HCEs in 1995; and the impermissible distributions to the non-HCEs in 1995. (While it is possible to fail the ADP test and only disqualify the CODA--cash or deferred arrangement--part of the plan, we have assumed for these purposes that the plan itself would be disqualified as a result of the ADP failure.) In this response, we will discuss the corrections for the improper distributions. In Q&A 42, we will describe the corrections for the ADP failure. To correct the excessive distributions to the HCEs, the plan administrator would need to request that the participants return the excess amounts to restore their account balances. However, in the past, the IRS has not required that plans undertake significant efforts to collect incorrect distribution amounts. We understand that the IRS may be reevaluating the degree of effort the plan is required to expend where the participants are HCEs and the improper distributions are large. In addition, the IRS could, in a VCR application, disqualify the individual accounts of HCEs who refused to return the excess distributions. The form of correction for the distributions to the non-HCEs would be the same, i.e., request the return of the amounts improperly distributed. Again, it is unlikely that the IRS would require significant efforts to collect these amounts. If the participants fail to return the excess distributions to the HCEs and/or the improper distributions to the non-HCEs, would the employer be required to contribute that amount to the participants' accounts? While correction often requires the employer to put more money into the plan, this is one instance in which the IRS does not require it. If the employer did so, the participant would get a windfall. The current IRS view is that the employer is not required to give a windfall to the participants in order to correct excess distributions. © 1997, Reish Luftman McDaniel & Reicher, a Professional Corporation. Elsewhere: |
