When had a "distribution" of excess contributions occurred?

[Guest Grumpy455]

When has a distribution of excess contributions occurred? Does it mean that the plan's account is actually debited, when a check is mailed to a participant, when a check is received by a participant, etc.?

Two HCEs in a client's 401(k) plan have excess contributions for the 2004 plan year (which is a calendar year plan year). The client has yet to issue checks to either HCE, but has been told by their benefits counsel that a "distribution" of excess contributions occurs if the check is dated March 15th or earlier--even if the check is issued after March 15. The client wishes to accept their lawyer's advice and issue checks to both HCEs now dated March 15, 2005 (so that (1) the HCEs will report the refunds in their 2004 taxes and (2) the client will escape the 10% excise tax). Is this OK? We have to prepare the 1099-Rs and want to make sure that we can, in fact, use code "P" instead of code "8".

We have always interpreted the regulations to require actual payment by March 15th which we think means the plan must mail the check to a participant no later than March 15th.

Thanks in advance for any comments.

[WDIK]

Maybe you should have your client issue a check to pay for their counsel's services around Christmas time, but date the check 4/1/05.

[E as in ERISA]

Remind everyone that what the IRS will normally see on audit is the plan records -- which I presume include the real date of distribution -- and not a copy of the check...

And I like WDIK's answer a lot....

[Effen]

Why not explain your position to the client and let them choose. Don't put yourself at risk for something you don't believe is correct.

If they choose the attorney's recommendation, let the attorney prepare the 1099s, or at the very least make sure you put a big caveat in the cover letter if you do them.

If they choose your recommendation, all is well for you.

Don't "bless" the transaction by issuing a 1099 that you believe is incorrect.

[mbozek]

I thought IRC 401k(8) and reg 401(k)-1(f)(4) permit distribution for up to 12 months after the close of the plan yr. Q-what does the plan say about return of excess contributions? Shouldnt that control?

[WDIK]

While the plan does have until the end of the plan year following the plan year for which the exces contributions were made to make the correction, there is the 10% penalty tax that applies if the corrections are not made within 2-1/2 months.

[Kirk Maldonado]

I would never advise someone to back date a check, particularly where that would affect taxes. Nor would I post a message on a public forum asking if I should get involved in a transaction involving back dating checks.

There is such a thing as tax fraud.

[mbozek]

I thought that under the tax law the distribution date is the date the check is mailed to the participant. Under a risk/reward analysis the issue is whether the client should issue the check with a current date and gross up the ee for the 10% penalty tax versus backdating the check. Paying the penalty tax is less risky than paying for advice on how to avoid it.

[rcline46]

Employee does not pay 10%, employer pays excise tax.

[Guest Grumpy455]

The basic issue here is not about tax fraud, Kirk. The basic issue is the specific point in time at which a corrective distribution of excess contributions has occurred. We cannot find any clear guidance on this issue--the guidance that we have found simply skirts the issue by explaining that depending upon when a corrective distribution is made, certain things happen (maybe an excise tax applies to the employer, maybe a different code must be used on a 1099-R, etc.). The guidance never explains when a corrective distribution occurs.

I believe the client's benefits counsel is incorrect that a corrective distribution occurs on the date on the corrective distribution check. If that were the standard, then there could never be a tax fraud issue, right?

Let me put my question more simply for everyone: Does a corrective distribution occur on the date a check is mailed to a participant or on some other date? If the answer is that a corrective distribution occurs on some other date, what date is that?

We appreciate all of the responses, but the real issues are being lost in allusions to tax fraud and other unrelated issues.

Mbozek has come the closest to answering our question when he writes that the distribution date is the date the check is mailed to the participant. Is there a citation for that conclusion or is it just a hunch?

[austin3515]

It is the day the check is sent in the mail.

What other rational measure could there possibly be? Certainly not the date of delivery, as this is well beyond the control of the sponsor. So that leaves... well nothing, so it must be the date mailed.

Think of how many mortgage payments would never be missed if they went exclusively by the date field on the check... It's better than a time machine!

[Bird]

I vote for the date mailed.

But...if the attorney is saying to backdate the check, and all parties are in agreement (that is, the HCEs are OK with it) then I don't have a problem with letting them do it. Call me a who... whatever. You need to get the money out by 3/15 so participants can prepare their returns timely, so if you don't, they don't have to report it in the prior year and there's a modest penalty for making their lives easier. It's not exactly a revenue raiser, and it's not like the IRS is going to make you prove anything in this case, like they would with proving a timely deposit of a corporate contribution.

If the HCEs getting the refunds are not on board, then I don't let them do it. My point being that the 3/15 date is more about protecting participants than anything else (IMO).

[Kirk Maldonado]

Grumpy455:

I guess I'm not understanding the situation. Here's what I understand the facts to be:

On March 29th, you post a message saying:

The client wishes to accept their lawyer's advice and issue checks to both HCEs now dated March 15, 2005.

I interpret that language as meaning that a check would be mailed on March 29th but it would have a date of March 15th on it. I presume that the purpose of backdating the check to March 15th would be to avoid the 10% tax.

To my way of thinking that would be tax fraud because the check would be prepared in a way to make it look like it was sent out by the deadline, when in fact, it was sent out after the deadline.

Please explain where I've gone astray, either on the facts or on the law (or maybe on both).

[Guest Grumpy455]

Thanks for all of the responses. I guess the consensus among those folks who have responded to the specific question, i.e., when is a corrective distribution made, is that a corrective distribution is made when the plan issues/mails a check (despite the fact that no one can provide an IRS citation confirming that conclusion). This is the conclusion we believed to be true, but questioned ourselves when we (1) could not locate a citation either and (2) where given contrary direction from the client's attorney (who, ironically, cannot provide a citation to support her position either).

[mbozek]

The accepted definiton for distribution is when the payor gives up dominion and control of the check, e.g. drops it in the mail. This definition worked well when checks were were written by hand, noted in a ledger and manually postmarked by the PO. Today checks are printed and dated by a computer, inserted into envelopes by machines, delivered to the PO by outside vendors after 5pm and mailed without postmarks which makes the distribution date difficult to determine. Many businesses pre date checks for the approximate date they will be mailed out, the date the funds will be available for payment or the date the checks were approved. While the distribution date has not changed the interpretation of when this event occurs has become more complex because of technology.

[WDIK]

Please explain where I've gone astray, either on the facts or on the law (or maybe on both).

It seemed like a bull's-eye to me.

[Guest mkimball]

good points about technology. Makes it difficult to determine when the postal service actually becomes the "agent", in a legal sense, for the recipient. That has been the long standing interpretation of all this if my recollection is correct.

[E as in ERISA]

In some cases, there is not a strict legal answer. It is more just a question of who is going to enforce the rule and what evidence are they going to review.

In this case, I think that the party that would most likely catch the failure to pay the 10% penalty is an IRS plan examiner. The focus of the IRS' review is generally the plan records -- plan sponsor and participant records and trust records. I'm assuming that those would reflect the correct post-March 15 date? And I assume that there would not be a copy of the check to the participant in the plan's records? (Is it going to be cut from the employer's checking account? In many cases, the amount would be debited from the plan's account and the check would be cut from the bank or trust company's account but I doubt that they'd be a party to this.) Is it likely that the only way that the IRS would see the check is if the IRS raised a question of the 10% penalty and the client responded by producing the check from their account that was backdated to pre-March 15. If that were true, I doubt that the backdated check is going to help the client at that point. It is going to make the auditor doubt the client's honesty and the audit will take on a different tone. Hence, Kurt's comments....

If the facts were different and the plan's trust was debited prior to March 15 but the check was actually dated after March 15, then I doubt that the IRS would look for the check unless it was a significant amount. If they did look at the check, then it might depend how late after March 15 it was actually issued, etc. If those facts are bad (large check issued a long time after March 15), then your client would have problems in that case too.

[Guest Grumpy455]

Ok, Kirk's conclusion is consistent with the others--a corrective distribution is made when it is, to use his phrase, "sent out". I do not think he missed anything. I take it that "sent out" means mailed (if sent physically) or issued (if sent electronically)? It is clear that I made a mistake in the post by including the facts--some respondents missed the question and focused on the goofy facts. The universal consensus, so far, is that a corrective distribution is made when it is mailed/sent-out. Given that an excise tax applies depending upon the timing of an act, it seems odd that the IRS has not more clearly defined the "line in the sand" before which the excise tax does not apply and after which the excise tax does apply. I wonder in the close cases how they justify the imposition of an excise tax. Thanks again to all of the respondents.

[WDIK]

It is clear that I made a mistake in the post by including the facts--

The more facts the better, IMHO.

[Kirk Maldonado]

Mbozek:

You brought up a very good point when you said:

Today checks are printed and dated by a computer, inserted into envelopes by machines, delivered to the PO by outside vendors after 5pm and mailed without postmarks which makes the distribution date difficult to determine. Many businesses pre date checks for the approximate date they will be mailed out, the date the funds will be available for payment or the date the checks were approved. While the distribution date has not changed the interpretation of when this event occurs has become more complex because of technology.

Do you have any suggestions about what an employer that is currently handling checks in that manner can do to generate proof about the date of the mailing? The absence of demonstrable proof could be very costly to the employer in some situations.

[E as in ERISA]

Can you use the process as the proof -- and use that to provide that the presumption that the check was mailed on the date that it normally would have according to that process? I thought that in Evidence they indicated that you can use the process for proof in court.

[Kirk Maldonado]

Katherine:

You are right. If you want to litigate the issue and try to convince the trier of fact, which would be the jury or the court, you can go that route.

Of course, there is no guarantee that you will be successful. The only guarantee is that you will incur a lot of legal fees in trying that case. Inasmuch as I'm not a litigator, I try to structure arrangements for my clients to avoid, not encourage, litigation.

I was just trying to see if there was some simple way of irrefutably demonstrating that it was mailed on that date where the process is automated.

[Guest Midas]

I believe the IRS opinion as to when income becomes taxable to an individual is relevant here. IRS Pub. 525 would seem to support the view that a corrective distribution is satisfied if the check is made available to the recipient, or an agent for the recipient by the required deadline date.

IRS Publication 525, "Taxable and Nontaxable Income" defines Contructively-Received Income as follows:

Constructively received income. You are generally taxed on income that is available to you, regardless of whether it is actually in your possession.

A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you do not cash the check or deposit it to your account until the next year. For example, if the postal service tries to deliver a check to you on the last

day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in

your income for the next tax year. Income received by an agent for you is

income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in income when the third party receives it.

[Kirk Maldonado]

Midas:

The constructive receipt rules no longer apply to distributions from tax-qualfied retirement plans, as a result of a legislative change to section 402 effected more than 20 years ago.

[Guest Midas]

Kirk - Thanks for the lesson. I am not implying the contructive receipt rule applies for taxability purposes. Just thinking in the absence of guidance, the methodology of determining when moneys are made available might apply when attempting to determine if a corrective distribution has occurred.

[Kirk Maldonado]

Midas:

You will note that I didn't question the validity of the way in which you analyzed the issue; I just pointed out a fact that I thought you were not aware of (because you didn't mention that the constructive receipt doctrine no longer applies to tax-qualified retirement plans).

My guess that if somebody did some digging, there's probably some guidance on this point because it comes up in other contexts as well (e.g., the return of excess contributions to an IRA). However, that guidance might be buried pretty deep, like in private letter rulings or general information letters.

[mbozek]

There are numerious cases under the 1986 tax act on when payments are made by an employer to an employee for income/ deduction purposes. General rule is taxable to employee in year made, not the year received, because employer claims a deduction in that year. Also Constructive Receipt was only repealed for taxation upon the occurrance of a distribution event. IRS still applies CR where an employee does not cash the check.

[Guest Midas]

Just spoke with an IRS agent about this. Only because this post has generated some concern on corrective distributions my office is currently in the process of completing.

Per IRS Agent:

Corrective action satisfied as far as the plan is concerned = moneys removed from trust.

As far as taxability to the HCE = constructive receipt rules apply.