HOW TO CORRECT EMPLOYEE DEFERRALS IN EXCESS OF PLAN LIMIT

[Guest ROB VIDOVICH]

A 401(K) PLAN HAS AN EMPLOYEE DEFERRAL LIMIT OF 10% OF COMPENSATION. A PLAN PARTICIPANT DEFERRED 20% OF COMPENSATION FOR THE PAST TWO PLAN YEARS, THE PLAN IS SILENT ON HOW TO CORRECT AN EXCESS ON A PLAN LIMIT VIOLATION. THE PARTICIPANT IS OVER 59 1/2, WHAT WOULD BE THE BEST WAY TO CORRECT THE EXCESS???

1) DISTRIBUTE THE EXCESS AND TREAT IT AS AN IN-SERVICE DISTRIBUTION AGE 59 1/2

OR

2) ADJUST THE PARTICIPANT'S SALARY REDUCTION AGREEMENT TO A PERCENTAGE TO MAKE UP THE AMOUNT OF THE EXCESS.

ANY ONE'S HELP WOULD BE GREATLY APPRECIATED.

THANKS.

[Archimage]

Neither. From the 1999 ASPA Meeting:

"42. A 401k plan allows participants to defer between 1% and 15% of their compensation. An employee elects 15% but, due to a payroll processing error, 17% of his compensation is deferred. The actual deferral is less than $10,000 and the error is not found until the subsequent plan year. There is no 415 violation. What, if anything, should the plan administrator do?

IRS: Refunding from the plan is NOT an acceptable APRSC solution, although it might work under VCR. The money should probably be forfeited and used in whatever way other forfeitures are used, with the employee being made whole outside the plan. However, we strongly argue that the "mistake of fact" argument does not apply to these contributions!"

[Guest svatty]

Actually, by using Rev. Proc. 2003-44 (instead of the APRSC that existed in 1999) you would be permitted, and actually should correct the error, by distributing to the PARTICIPANT the excess amounts (as adjusted for earnings). We have verified this with the IRS on several different occassions. Whether or not you can "self correct" this problem under the new rev proc is an issue to evalute under the conditions set forth regarding scp.

The Plan document provided a participant could not exceed / defer above a certain percentage. An operational failure occured when amounts above that amount were permitted to be deferred. The amounts consequently could NOT have been deferred and thus to put the plan back into the position it would have been had no error occured, you are required to distribute the salary deferrals back to the participant. Forfeiting salary deferrals raises interesting problems which, even if permissible, should really be avoided if at all possible. The new rev proc defines Excess Amounts very interestingly so as to, as many practicioners believe, actually cover this problem (Part III, Section 5.01(3)(f)) and thus you would correct this Excess Amount problem just like a 402(g) excess and distribute the funds as quickly possible to the participant as adjusted for earnings.

[Guest cease]

If the plan document allows for catch-up contributions, and the plan years in question are 2002 and 2003, then $1,000 of the overage could be classified as catch up for 2002 and $2,000 for 2003.

Beyond that, the advice to look at Rev Proc 2003-44 is the next logical step.

[R. Butler]

I agree with svatty. I would refund the excess deferral to the participant. I also agree with svatty that forfeiting the contributions is not a good option. After my own research & consulting with other attorneys, I came to the conclusion that refunding the deferrals in these instances is a "reasonable & appropriate" correction. You will get others, however, who strongly disagree.

[Guest ROB VIDOVICH]

I agree with svatty. I would refund the excess deferral to the participant. I also agree with svatty that forfeiting the contributions is not a good option. After my own research & consulting with other attorneys, I came to the conclusion that refunding the deferrals in these instances is a "reasonable & appropriate" correction. You will get others, however, who strongly disagree.

In regards to the tax reporting on the refund, a 1099-R would be issued reporting this as a taxable distribution. Would this participant be able to rollover the amount of the distribution or treat it as a corrective distribution, in which it would not be eligible for rollover????

[R. Butler]

As svatty suggest we treat excatly like a 402(g) excess.

[Archimage]

I tried to find some research to support your positions. After reviewing the the EPCRS procedures I do agree that refunding may be a possible solution. There is no actual guidance that I could find (let me know if I missed it). The ERISA Outline Book suggests that the correction should be a forfeit of the deferrals but this was before Rev Proc 2003-44 was issued. It seems that this is a similar situation to having an ineligible employee deferring before his entry date. I think in both situations either method would can be used.

[R. Butler]

Archimage,

I know that many practioneers will do you as you suggest, but I've always been concerned about what basis there is to forfeit a deferral. I adopt the treat it as a 402(g) excess theory because that really is what it is most akin too. Although I don't treat it as a "mistake of fact", I can follow the logic, I just arrive at a different conclusion. Other than lost participant scenarios, I can't find a basis to ever forfeit deferral money.

Also, I have difficulty with the fact that really half of the correction takes place apart from the plan. There is nothing within ERISA that I am aware of that requires the employer to make the participant whole (I realize that the participant does have remedies, just not within ERISA). It just seems cleaner & more logical for the entire correction occur within the plan.

[Archimage]

I would agree with you that a refund is more logical. Unfortunately we are in an illogical business with an illogical IRS.

[R. Butler]

Agreed.

[KJohnson]

I think distributing is an option, but I am not sure that the definition of excess amount gets you there. To find support there, you first have to come to the conclusion that the deferral has to be distributed to maintain the qualification of the plan--which was the question in the first instance. The definition states:

(f) any similar amount that is required to be distributed in order to maintain plan qualification.

You may find more support under the general correction principle that says that when correcting an excess allocation, amounts should remain in the Plan--but specifically excludes a CODA:

For example, if an excess allocation (not in excess of the § 415 limits) made under a Qualified Plan was made for a participant under a plan (other than a cash or deferred arrangement), the excess should be reallocated to other participants or, depending on the facts and circumstances, used to reduce future employer contributions.

Conceptually, this would not seem any different than an ineligible employee deferring--the contributions should not have been received in the first instance under the Plan. Of course with this defect, you don't have the retroactive amendment option. As to ineligilble employees deferring, Tripodi in his outline says that either forfeiting or distributing is an option (if you don't want to amend).

[KJohnson]

My last post was before I saw the last four or five. I would note that the definition of excess amounts was the same under 2002-47 so I am not sure whether Sal will change his advice based on 2003-44

[imchipbrown]

Anybody like a retroactive amendment? If it's a non-highly comp'd ee, I'd love to keep a 20%er in the ADP test.

[Archimage]

I believe the problem with a retroactive amendment is that you have to submit the amendment via the VCP. That can costs more and be more time consuming.

[Guest svatty]

Just to follow up on my original post and some comments that have been provided. We have spoken with Joyce Kahn on this issue for several different clients and she basically points at the definition of Excess Amounts and says if you didn't correct the over deferral problem the IRS could disqualify your plan (we all know they never would) and thus that correction procedure is appropriate. If I remember correctly she then went to the next step of pointing to the rev proc and stating that such a correction would be similar to other approved code / reg corrections and thus satisfactory to the IRS.

The 2002 rev proc was similar and our advice would be the same under that rev proc. My comment on the "timing" was simply to show that the 1999 APRSC stuff should not be relied upon.

Just my two cents! I am aware that others still disagree with this method of handling the problem, but we have become very comfortable with it. If I remember correctly we have used this with IRS approval through both audits, VCP and informal calls on SVPs for clients seeking same correction without IRS approval.