Self-Correction of "Accidental" Distribution

[billfgrady]

A plan participant was allowed to take a $5,000 distribution on the mistaken belief that a 401(k) profit sharing plan allowed participant loans. This is not the case and the participant is not otherwise entitled to take a distribution. We expect that the easiest (only?) way to resolve this is to report this to the Service (through EPCRS) or to self-correct, have him pay the tax on the distribution and any penalties, including early withdrawal, that apply. In other words, we should treat this as a deemed distribution under Section 72(p) of the Code. Has anyone encountered similar circumstances? Does self-correction cover this?

[mbozek]

If the participant was not legally entitled to the distribution why not have him pay it back to the plan and rescind the transaction on the grounds that there was no entitlement to the funds. Of course the distribution and recission must occur in the same year and both parties must be put back to the same position they were in before the funds were paid. You need to discuss this concept with tax counsel who understands rescission under the tax law.

[billfgrady]

I would have considered this option, but for the fact that the distribution was made in 2003 and not discovered until this year.

[TBob]

Following the correction principal of putting the plan (participant) back in the same position it would have been in had the error not occurred, the participant should repay the money.

In one of my past lives in dealing with impermissible distributions that were not repaid by the end of the tax year, we tax reported them on a 1099Misc if they were over $600.00. The theory behind this was that the distribution was not a proper distribution from a qualified plan and therefore should not be reported on a 1099R. The participant must include the distribution as income for the year distributed. For what it's worth, I have yet to get anyone on these message boards to agree (or vehemently disagree) with the 1099Misc idea.

If the participant does pay back the distribution in a subsequent year, they claim a deduction in they year they repay it using the "Claim of Right" doctrine. I can't remember where the IRS documented the "claim of right" theory but no tax preparer ever appreciates it when you suggest this method. Every one I have ever encountered wants the 1099Misc amended, destroyed, revoked or something of the like.

Those of you that disagree with this, please post because I am curious how others handle this as well.

[Guest jfp]

The EPCRS rev. proc. says the distribution should be reported on a 2003 1099R. The rev. proc. also says that the employer/plan sponsor must explain the tax ramifications to the participant and demand repayment plus imputed earnings. It is left up to the participant to determine if and how if can claim a corresponding tax deduction if he pays the money back. Also, if the participant does not repay the money back, the employer must repay the money.

[billfgrady]

Where in Rev. Proc. 2003-44 does it say that?

[mbozek]

That makes no sense- Why would the employee refund the money if it is a taxable distribution? Also if the employer returns the funds whose account do the funds go into? The employee's?

[Guest jfp]

I am referring to the provisions of the rev proc relating to "overpayments." I don't know, but I think the IRS would expect the same type of "correction" where it is not an overpayment per se, but merely an impermissible distribution.

Start with Section 6.06, and also look at Section 2.05 of Appendix B.

[TBob]

jfp - I guess I agree with you that one can make the leap to apply the same principal the IRS spells out for overpayments to impermissible distributions. Thank you for setting me straight on the 1099R vs 1099Misc issue as well.

mbozek - The employee would return the funds for several reasons...First and foremost, to keep the money tax deferred for retirement which we all know is the most important thing to all plan participants (ha ha). The participant will have to pay taxes on the distribution in 2003 but will get a corresponding deduction in 2004 (assuming they repay in 04).

I assume that the participant did not want the unanticipated tax impact of the distribution when they thought they were taking a loan.

If the participant is unable or unwilling to repay the distribution, it does not make sense to me for the employer (or anyone else for that matter) to make the plan whole in this case. Since the money came out of the participants account, any repayment would go back to the participants account. The participant should not receive a windfall because of the situation. The sections of the Rev Proc pointed out by jfp talk about having the employer or someone else pony up the difference when the overpayment resulted in a shortage to other participants in the plan.

That's my 2 cents worth...

[billfgrady]

After digesting all of this, along with Rev. Procedure 2003-44, here is where I am on this right now. The distribution is clearly a "deemed distribution" under Section 72(p) and will be included in the participant's taxable income for 2003. Thus, the plan needs to issue the participant a 1099-R for the entire amount of the distribution. Subsequently, the participant needs to pay back the entire amount of the distribution to the plan (plus interest, I assume). We are going to take the position that the participant does not get a deduction for this payment under the "claim of right" doctrine; rather, we think he simply has additional basis of $5,000 in his plan account.

Here is a related issue: there was no withholding on the distribution and, obviously, no Form 945 was filed by January 31, 2004. Should the $1,000 of withholding be paid from the plan or from the participant's pocket? Do you foresee any issues with the 945? I think there is a $250 penalty but I can't think of anything else.