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It is the famous IRS notice generator issue. It takes time for the extension to be entered into the system. Last I heard, it was still mostly a manual process. The process has been even slower the last few years. If the return is recorded before the extension, a late notice is generated and mailed automatically. There is also a delay between when the 5558 is entered and when the system recognizes the extension.

When an employee retires from the employer maintaining the plan is determined based on all the facts and circumstances at the time the determination is made. If this person is re-employed within the same calendar year before any distributions were required, then no RMD would be due for that distribution calendar year. I don't think that paying a distribution is necessarily "safer" if the plan wouldn't allow in-service distribution if the participant is still employed.

I don't believe this would be a prohibited transaction (requiring deposit of lost earnings and payment of excise tax under sec. 4975) since the employer is not getting any use of the plan assets, like they would if they had held on to the actual contributions. Instead it sounds like the participants' investment selections are not being honored. What happens in that case is I think you have an ERISA 404(c) failure, the consequence of which is that the fiduciary is no longer insulated from the participants' investment choices. Potentially the participants could sue the trustee if they had a loss caused by failing to follow their investment instructions.

The plan asset regulations depend on whether the money is held in the trust, not whether it has been invested according to a participant's investment direction. If you have not violated the plan document, then you don't have a compliance problem. Note that the trustee repeatedly investing money in cash for a few days each payroll period will not comply with ERISA 404(c), so it may lead to employer liability.