Money refunded due to ADP test was never participant's.

[KateSmithPA]

This is so confusing, I am not where to start in correcting it.

Plan failed discrimination test. Money was returned to one HCE.

Now, employer tells us that they deposited $1,500 too much to the account of the HCE who had the refund. This $1,500 was never withheld from his compensation and was not reflected on his W-2. However, it was deposited into the plan as a salary deferral and contributed to the failure of the discrimination test.

The HCE received more than $1,500 in his refund. So, he received a refund of the money that was contributed to his account by mistake of the employer.

Where do we start to correct this problem?

[mbozek]

You are going to need counsel to advise you on how the straighten this mess out. One way is to apply a recission theory to remove the funds that the employee was never entititled to receive from the plan on the grounds that it is an excess benefit. See Reg. 1.401(a)-13©. Under Rev. Rule 79-311 the employee should not be taxed on the receipt of funds that he was never contractually entitled to if the funds are refunded to the employer. However, in RR 79-311 the funds were retruned in the same year they were paid to the employee.

[Mike Preston]

I agree that you will probably need to consult with counsel before this is all said and done.

But it seems to me that you have two issues. 1) A flawed ADP test (and therefore flawed corrections) 2) Monies deposited into a plan as a mistake in fact (finally, a real mistake in fact, at least it looks that way).

1) Redo the ADP test, considering the correct deferrals only. This will probably lower the required refunds to not only this HCE, but all other HCE's who deferred more than the resulting allowable dollar amount.

The likely result from this is that for each HCE (other than this particular HCE) who has their refund affected by the results of the modified test you have made an over-correction. Get it back from them, or have the employer make the plan whole. For this specific HCE, the same thing goes, but you have an additional amount to collect from him (the $1,500). See the latest incarnation of EPCRS to see what options you have. If corrected soon enough, it sounds like it would qualify for SCP, but you'd need to decide that in conjunction with counsel.

2) Once the employee is ready to return the money you then need to decide who that money is returned to. You don't indicate whether that $1,500 was really intended for another participant or not. If so, it gets even more complicated.

Of course, if the employee won't return the money, you have more issues.

And, if the investment of the funds by the employee has resulted in less money now than when it was given to him/her, that is another kettle of fish to deal with.

Just some thoughts to help focus the issues.

[KateSmithPA]

Thank you, both, for your help. It certainly is a mess.