ADP Failure, Late Distributions and One to One QNEC

[buckaroo]

If you fail an ADP or ACP test, you have 12 months to make a correction. If you don't make a correction within the 12 month prescribed correction period, then you have a failure on your hand. You can use the One-to-One Correction Method, which involves the refunds being made and a QNEC allocated to the NHCE's.

I have a client who failed their 2003 ADP test. The test was completed in 2/2004. They did not properly process the distributions. Now it is 2007, they want to make the proper distributions. We told them that they could still make the distributions to the HCEs (with the applicable earnings), but they would also have to make the 1-to-1 QNEC to a group of the NHCEs. We reviewed the original corrective distribution calc, brought forward with earnings and told them how much needed to be distributed. We then attempted to calc the 1-to-1 QNEC. When we did so, we came up with an HCE who gave us some problems:

HCE: He terminated in 1/2004. He rolled over his funds in 2/2004. For his situation, he would still need to be notified of the corrective distributions and need to get some of the funds out of his rollover vehicle. Our questions/comments are as follows:

1) Since he took his funds prior to 3/15/2004, the employer would not have to include him in the 10% excise tax for the late distributions. (if he took his dist after 3/15/2005, then he would need to be included in the 10% tax calc. Correct?)

2) He would need to receive a 1099R in 2007 showing the taxable distribution. Correct? Do we need to provide that to him or should that be issued by his IRA based on our letter?

3) Since the funds were taken from his account prior to 12/31/2006, does he need to be included in the 1-to-1 QNEC calculation? I believe that he should because even though all of his funds were distributed, the distribution was not done properly. Does anyone agree? Can anyone please provide a cite?

Any replies are greatly appreciated.