Mistake of Fact Distribution

[Guest lindamichals]

What is the IRS position on returning contributions to employees who were allowed to defer before their eligibility requirements were met? What happens to the gain(if any)? Does the money go back to the plan sponsor and they run it through payroll again or does the employee get a 1099R? Thanks.

Linda Michals

[Tom Poje]

I would hold the "preferred" method is found in Appendix B, 2.07(3) of the self correction program. If it prints the same as mine, it would be page 88 fron the following web site:

http://www.irs.ustreas.gov/pub/irs-drop/rp-06-27.pdf

namely, leave the money in the plan, amend the plan to alow the particular person to be in the plan.

There is no example elsewhere in the self-correction about returning the money, or making the person whole outside the plan or whatever, though I know in practice that is done. Again, the comment mentioned above is the preferred method. that does not mean other possibilities do not exist. one argument for returning the money is that you are to put the plan in a position as if the error didn't occur. on the other hand the IRS prefers you leave money 'in the plan' so you get stuck in a vicious circle. If you correct by amendment (making the person eligible) then you know you are safe. if you self correct by returning the money and the plan gets audited, you could always have the IRS say where is that permitted.

[Archimage]

Another common correction method is to forfeit the contributions and have the employer correct on their payroll outside of the plan.

[John Feldt ERPA CPC QPA]

If these were contributions made to the plan before the plan was even executed (adopted, signed), then I think the deferrals are considered excess deferrals (the IRS doesn't want deferrals to occur before a plan is adopted).

[Below Ground]

A potential problem with amending the plan to make that person eligible is that this may make other people eligible, and could adversely impact testing. (Restructuring could help here.) Beyond that, do you now need to make a contribution to those people to reflect that they were not made aware of their right to defer under the plan? "Vicious circle" is an appropiate description. I have yet to see any position that does not have problems.

[Guest rgorman]

We have taken the approach of forfeiting the deferrals and making the employee whole outside the plan through payroll. If we have related match, we forfeit the match as well. We also normally calculate earnings on the amounts involved using actual investment returns or a safe harbor return depending on how the investments are done. In doing this, no distribution occurs to the participant so no 1099R.

If it crosses plan years, my question is if you have to revise the W2 for the participant or since it is taxable income in the year corrected, does it matter? I have also had clients ask if they have to go back and adjust the 941 or 5500, and my response has been no since it will be accounted for in the year of correction. Anyone do anything differently?

[Guest lindamichals]

If the employer decides to adopt this correction method, would this employee also become eligible for employer contributions? The plan has a safe harbor and profit sharing contribution coming for 2006. I don't think he would have a problem letting her keep her money, but he would have a problem with having to give her safe harbor and profit sharing before her entry date. Thanks.

I would hold the "preferred" method is found in Appendix B, 2.07(3) of the self correction program. If it prints the same as mine, it would be page 88 fron the following web site:

http://www.irs.ustreas.gov/pub/irs-drop/rp-06-27.pdf

namely, leave the money in the plan, amend the plan to alow the particular person to be in the plan.

There is no example elsewhere in the self-correction about returning the money, or making the person whole outside the plan or whatever, though I know in practice that is done. Again, the comment mentioned above is the preferred method. that does not mean other possibilities do not exist. one argument for returning the money is that you are to put the plan in a position as if the error didn't occur. on the other hand the IRS prefers you leave money 'in the plan' so you get stuck in a vicious circle. If you correct by amendment (making the person eligible) then you know you are safe. if you self correct by returning the money and the plan gets audited, you could always have the IRS say where is that permitted.

[Guest lindamichals]

Exactly how is this done? If the plan forfeits the deferrals, would the money then go back to the employer so he can run it through his payroll again? To me, forfeitures means transferring the amount to the plan's forfeiture account, so I need clarification regarding this method. Thanks.

We have taken the approach of forfeiting the deferrals and making the employee whole outside the plan through payroll. If we have related match, we forfeit the match as well. We also normally calculate earnings on the amounts involved using actual investment returns or a safe harbor return depending on how the investments are done. In doing this, no distribution occurs to the participant so no 1099R.

If it crosses plan years, my question is if you have to revise the W2 for the participant or since it is taxable income in the year corrected, does it matter? I have also had clients ask if they have to go back and adjust the 941 or 5500, and my response has been no since it will be accounted for in the year of correction. Anyone do anything differently?

[Guest rgorman]

No monies revert back to the employer.

The deferrals and match with applicable earnings are forfeited and put in the plan forfeiture account for future use based on the plan document provisions.

To compensate the employee for just the deferrals that were withheld and forfeited, the employer gives the employee the same amount as earnings in the year of correction.

This is an attempt to put the plan and participant back in the same position it would have been had the error never occurred.

Hope that clarifies.