Corrective distributions

[Belgarath]

Grrr! I'm glad I don't work with these darn things (401(k) plans) much! This will undoubtedly seem like a foolish question to those of you who do, but here goes...

Had a couple of questions come up which are fortunately hypothetical. Of course, I find that most of the hypothetical questions subsequently turn out to be real.

1. Suppose you have an employer who incorrectly calculates a QNEC or a match, and contributes too much. This could be forfeited and used to reduce future cost, I believe. But suppose they don't want to do this? Can this be refunded to the employer under the "mistake of fact?" PLR 9144041 does list a mathematical error as one of the items that could be construed as a mistake of fact. I'm always squeamish about refunding money to the employer if it can be avoided, but it seems as though probably ok in this situation. Opinions?

2. Ineligible participant is allowed to defer. Employer does NOT want to use the Rev. Proc. 2003-44 Appendix (B) method of retroactively amending plan to include the employee. So attempting to find a "reasonable" method of correction, it would seem that you could forfeit the deferrals and have payroll adjust the next check to the employee. Or, the plan could probably distribute directly to employee. Question is, what to do with any match and earnings on the improper deferral, especially if this isn't discovered for a while? Does the normal prohibition against keeping in an unallocated suspense account (1.401(m)-1(e)(1)(iii) as an advance apply to this situation?

[FundeK]

Here are my opinions....

1. I am also very hesitant to use a "mistake of fact" as a reason for distribution. If the employer's payroll calculated the match incorrectly, then yes, I would say it is a mistake of fact. If the payroll assumed the match formula was "A", but it was really "B", then no, that is not a mistake of fact; the PLR you mentioned specifically says assumptions are not mistake of facts. I would always err on the side of caution and forfeit the money. Convincing the ER to do this is always a challenge.

2. I would not have the plan distribute to the participant. A 1099 should not be issued in this case. This money needs to run through payroll and be taxed appropriately. Here is a link to a previous discussion about an ineligible employee deferring.

http://benefitslink.com/boards/index.php?showtopic=22511

[Belgarath]

Thank you. In one way, this makes me feel a lot better - there are a lot of different opinions on this garbage, and not a lot of concrete answers, so maybe I'm not as stupid as I think. I'll count on the rest of you to be charitable in this regard...

On situation # 1, we never recommend a refund under mistake of fact. But we do tell them to consult their legal counsel, and if counsel advises them to go ahead, then that's ok with us. I will say that this situation seems probably defensible - if you multiply 2 times 2 and get 6, as we've all done when stressed, it would seem to qualify.

Re # 2, reading the various comments, it does seem as though the IRS has a fairly strong bias against refunding to the participant. (Not terribly rational, IMHO) but they hold all the cards. The link you attached was very helpful. I'm inclined to agree with Mike Preston, who doubted if the IRS would actually do anything if you went ahead and refunded. But, if you did jump into the deep end and go ahead and refund, that still leaves the open question on how to handle the match and earnings?

[Mike Preston]

Random comments:

1) No charity needed.

2) I usually get 6.0000001

3) What match? If there weren't deferrals, there weren't matches. What they were, I don't know. But they weren't matches! Best case? They were also MIF, and the earnings were negative so nothing to do other then pay out from the plan those amounts contributed reduced by losses. What? Gains not losses? Bummer. I'd try real hard to leave them in the plan and re-allocate them.

[FundeK]

I can't see how you could do anything but forfeit the earnings and match. It definitely won't be sent to the participant. Can't send to the company (reversion of assets). Wouldn't call it a mistake of fact....

I thought I read somewhere or attended a seminar were they discussed a correction method where you could amend retroactively to include only the affected participant by actually stating the participant's name in the amendment. Has anyone heard of this?

[Belgarath]

Mike:

1. Tell that to my wife!

2. I laughed at this one for 5 minutes.

3. I agree with you and Fundek - forfeit and reallocate. It's just annoying to have to go to this extreme, as I agree, how can you have a match on money that shouldn't have gone into the plan in the first place? In a slightly more sane world, this should simply be refunded to the employer. By the way, what does your "MIF" stand for?

I thank you both for your input.

[mbozek]

Since a plan must be administered in accordance with its terms, the funds deducted from the paycheck of an ineligible ee must be returned to the employer so that they can be refunded to the employee. Otherwise the er is liable for the failure to pay wages to the ee under state labor laws. Since the mistake of fact provision in ERISA was written before 401(k) plans were authorized under the tax law to permit employee contributions it should not be construed to prevent the correction of a mistake. There are numerious IRS rulings which permit the correction of mistakes in compensation without any adverse tax consequences to the employee, eg. Rev. Rul 79-311, refunds by employees of amounts previously paid by employer as commissons to employees for which employees were not entitled is not taxble income.