How do you get a refund/credit of a participant's prior year's federal tax withholding?

[Guest cicday]

A participant elected a lump sum distribution in 2002. The distribituion check was made payable to the participant; Federal & State taxes were withheld and remitted to appropriate agencies and a 1099R issued.

It is now mid-2004, the distribution check (still uncashed & in the Plan Sponsor's possession) is endorsed over to the Plan Sponsor by the Participant (to repay a previous loan made by the Employer to the Employee).

In December 2004, the Plan Sponsor learns that this transaction violated the anti-alienation rules and therefore immediately restores the Participant's account to where it was just prior to the 2002 distribution.

How does the Plan Sponsor recover the Federal taxes that were withheld in 2002?

[Guest b2kates]

no, it is the participant who needs to seek the refund of the deposited tax monies.

under your situation there is now 3 tax years that have passed; 2002 and 2003 and 2004.

In the past I was the compliance tax manager for a major bank trustee. We determined that it was only appropriate to seek the refund at the plan level when the funds were returned to the trust during the same tax year as the initial distribution.

Question, what violated the antialienation rule?

[Guest DonnaD]

I haven't researched this, but somehow I had the idea that if it was voluntary on the part of the participant, it was OK to sign over a check to the employer. I imagine the burden of proof would be on the employer to demonstrate that it was in fact voluntary....

Interesting that the check wasn't cashed for all that time....

[david rigby]

It is doubtful that a check issued in 2002 will still be valid in 2004, at the time it was endorsed.

Unclear if the anti-alienation provisions were violated. The plan sponsor may have accepted a "payment" that is worthless.

[mbozek]

If the payment was reported on the 1099-R in 2002 then the employee would have been taxed on the distribution and the taxes withheld would have been credited in against those owed for that year even if the check was not cashed. I dont see how signing over the check to the er in 2004 changes the fact that the ee paid taxes on the distribution in 2002. The failure to give the check to the ee is a violation of ERISA which can be rectified by a distributon to the particpant with accumulated interest. The employee could argue that there was no distributon in 02 because the check was never received but the ee would have to file a refund request on account of the fact that there was no distribution. The plan admin should issue a corrected 1099 showing there was no distributon in 02. The employee needs to consult a tax advisor.

[Bird]

The participant completed the forms and taxes were withheld and paid and a 1099-R issued; the participant never cashed the check and it appears that the sponsor never gave it to him.

Assuming the above is correct...

First observation is that it's obviously screwed up. And the plan is NOT getting money back from the government.

I'd argue that part of the distribution was completed - the withholding is a distribution, it just happens to go to government agencies. So the technical answer is that the 1099-R should be reissued, showing a smaller amount for the total distribution, and 100% of it being withheld. Then you're looking at re-doing the valuation report(s) to show a partial distribution and a continuation of the account for 2002, 2003 and 2004.

But, I'd guess that the participant reported the distribution on his 1040, since he presumably received the 1099 that was issued. I think I'd want to know that one way or another. But it appears that he's party to the screwup by not asking for the balance, and compounding the problem by reporting it as if he received it.

If those assumptions are correct, I'd be inclined to go for a practical solution, which involves leaving the 1099 and the tax return as is. Since the problem has been compounded by taking the check back and reinstating the account, I'd cut another check back to the participant and say "here's the amount we didn't withhold. If you really want to reinstate your account, you can give it back to us, but you also have to come up with the difference (the amount withheld)."

I might recommend the technical answer above if I knew there was a lot of money involved.