gcrechale - In situations like this in the past, we have always started with asking the participant to refund the money. It is not an easy thing to get them to agree but you might get lucky. We have also always operated under the correction principal of putting the plan back in the position that it would have been in, had the error not occurred. An impermissible distribution is a operational defect and we would apply the appropriate self correction program.
In the past couple of years we have stopped putting money back into the participants account if they would refuse to refund it themselves. It was our understanding that the IRS had agreed with your thinking that the participant should not get a windfall out of the situation because of the error. I unfortunately, have no back up for this reasoning and can't quote any speaker from an ASPA conference or IRS notice, etc. that blessed this method.
We would simply ask for the money back and if it did not come back by the end of the year, we would tax report it on a 1099Misc rather than a 1099R. The reasoning here is that the distribution, since it was not based on a distributable event from a qualified plan, should not be reported as a distribution from a qualified plan. Again, no back up for this method but it seemed reasonable to us.
For what it's worth, that's how we handled these situations. I would like to hear from others to tell me if we were way off base or not!
