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I agree that this is NOT a plan issue and that the money impermissibly withheld was not taxable in 2017, either for FIT purposes or FICA/Medicare, but is taxable if and when it is paid to the employees. For $10 per person and $700 total the technically correct correction is way too complicated. That would entail filing and distributing corrected 2017 W-2s to back out the amount reported as FICA/Medicare wages and filing a 941c for the fourth quarter 2017. I think the simplest reasonable approach is to just pay the employees what they should have received, report it as current W-2 wages, and withhold the FIT and FICA/Medicare taxes. Yes, they and the employer will be paying the FICA/Medicare tax twice on the same dollars, but on $10 that amounts to a maximum of $0.765 each for the employee and the employer. If you skip the FICA/Medicare taxes on this payment you will be asking for trouble from the IRS. Whether State employment law requires something further beyond just paying out the $10 is not something I know anything about.

I still think that you are overthinking this. It has NOTHING to do with the plan. The employer kept some money from the employees that they shouldn't have. The employer now needs to give it to the employee. Yes, the 2017 w-2 shows incorrect deferrals, but it doesn't change their tax situation. They paid taxes on everything they got. I think the employer gives them the money now and moves on.

This sounds like a payroll error to me. Talk to your payroll company about how to fix it. You MAY have to contribute something to the plan but since the withholding wasn't authorized, it should have been corrected by payroll anyway. Had the fund been deposited into the plan, it should probably be refunded.