Incorrectly included 401(k) participant (not 21 until recently) - how to fix?

[Guest GNagler]

A client with a 401(k) plan has discovered various issues. The first set had to do with non-filing of Forms 5500 since plan inception in 2001. An easy fix under DFVC. However, now the client has discovered something else, and I'm wondering if there are any thoughts.

There is currently and historically has only been 1 participant. It turns out this participant was not really eligible, as he did not turn 21 until just recently. So, the only asset the plan has ever had has been pre-tax deferrals from this incorrectly included participant (there is no employer contribution under this plan). First, under voluntary compliance, does anyone know if disgorging the contributions is the correct answer? And if so, would it be 2003 taxable income, or would you have to go back and restate income for 2001 and 2002 (and is it a 1099-R from the plan or a W-2 from the employer issue). Finally, if you disgorge, the client would like to say the plan never existed, i.e. there was never really a trust corpus. I cannot see how that final answer would work, as the plan had eligible participants who were deemed to benefit, although none elected to do so, and there was an actual asset in the trust, even though it would (under what we now know) show up as a payable back to the participant.

Any thoughts would be appreciated.

[Guest eafredel]

There are several older revenue rulings that state that an employer with no employees who are eligible to participate in the plan may not maintain a qualified plan. See Rev. Rul. 70-316 and Rev. Rul. 55-629. Similarly, an employer may not continue to maintain a qualified plan if it ceases to have employees, active or retired, who participate or receive benefits. If the employee was at least 18, the minimum age under the plan should have been set at 18 (not 21) when the plan was established. Are you sure the minimum age under the plan was set at age 21? If so, it sounds like a qualified plan was not established.

[Guest eafredel]

If there were employees who elected to participate (who elected not to make elective deferrals) and the plan includes a trust, your client might have an argument that the plan was properly adopted but the trust did not come into effect The argument would be that if benefits are provided under a trust, a trust was not validly established under trust law (here looking at the applicable state law) since the only assets constituting the trust corpus came from an ineligible employee.

[KJohnson]

It sounds like your employee may be an HCE as a 5% owner. If not, however, you may be able to self correct using the plan amendment correction method found in EPCRS and pasted below. Note that this procedure can only be used if "the employees affected by the amendment are predominantly nonhighly compensated employees"

(3) Inclusion of Ineligible Employee Failure. (a) Plan Amendment Correction

Method. The Operational Failure of including an ineligible employee in the plan who

either (i) has not completed the plan’s minimum age or service requirements, or (ii) has completed the plan’s minimum age or service requirements but became a participant in the plan on a date earlier than the applicable plan entry date, may be corrected under VCP and SCP by using the plan amendment correction method set forth in this paragraph. The plan is amended retroactively to change the eligibility or entry date provisions to provide for the inclusion of the ineligible employee to reflect the plan’s actual operations. The amendment may change the eligibility or entry date provisionswith respect to only those ineligible employees that were wrongly included, and only to those ineligible employees, provided (i) the amendment satisfies § 401(a) at the time it is adopted, (ii) the amendment would have satisfied § 401(a) had the amendment been adopted at the earlier time when it is effective, and (iii) the employees affected by the amendment are predominantly nonhighly compensated employees.

(b) Example

Example 22:

Employer L maintains a 401(k) plan applicable to all of its employees who have

at least six months of service. The plan is a calendar year plan. The plan

provides that Employer L will make matching contributions based upon an

employee’s salary reduction contributions. In 2001, it is discovered that all four

employees who were hired by Employer L in 2000 were permitted to make salary

reduction contributions to the plan effective with the first weekly paycheck after

they were employed. Three of the four employees are nonhighly compensated.

Employer L matched these employees’ salary reduction contributions inഊaccordance with the plan’s matching contribution formula. Employer L calculates

the ADP and ACP tests for 2000 (taking into account the salary reduction and

matching contributions that were made for these employees) and determines that

the tests were satisfied.

Correction:

Employer L corrects the failure under SCP by adopting a plan amendment,

effective for employees hired on or after January 1, 2000, to provide that there is

no service eligibility requirement under the plan and submitting the amendment

to the Service for a determination letter.