Failed ADP

[Guest pensiondoc]

If an HCE has to take back money for the 98 year before 3/15/99, does he claim it as income in 98 or 99? I know to give a 1099R for '99 so wouldn't he claim it as income in '99??

[LCARUSI]

It is taxable income for 1998 (assuming distribution prior to 3/15/99).

The participant receives a 1999 1099-R. You should use the distribution code which indicates it is taxable income for the prior year (1998).

[Guest Mike Kimball]

I believe that it also requires filing an amended 1998 tax return to reflect the additional taxable income. At Least that's what I'm telling my clients.

[Disco Stu]

If it isn't too late, it would be helpful to tell the affected HCE not to file his/her 1998 taxes yet. If they haven't filed yet, they can still get the taxable income on the 1998 return.

The 1099 likely won't come for another 10 months, but as long as they have some documentation as to what the refund is for, they should go ahead and put it on their orginal 1998 return.

[Guest Mike Kimball]

Stu: As an individual taxpayer, I would agree that putting it on my 1998 return currently would be OK. That's because I know how to respond to any IRS inquiry about the 1999 1099R form. Unfortunately the typical small business client isn't all that informed about the requirements of the various forms that we file. Therefore, a lot of time is spent explaining things to the client. Afterwards, they usually just scratch their head and walk away wondering what you were talking about!

[Disco Stu]

I certainly agree with your point. It does happen that many people are confused by the situation. Given that fact that the people getting the refund are by definition the HCEs and generally the decision makers at the company, I've found it's better to give them as much information as possible up front. Many of these people have professional tax preparers. Some of them actually do understand the situation themselves.

If they really do not underdstand why the distribution is taxable in a prior year, I can see why when January 2000 rolls around they would be irritated that they have to go through the time and expense of refiling their 1998 return. I would just as soon not be the messanger that get shot in that situation.

I guess in short, my position is that more information is better than less. Those that are able to use the information would hopefully appreciate that their service provider was looking out for them. The others are going to be confused either way.

[Guest ATaylor]

A couple of more thoughts.... I agree that communication is key here. The Plan Sponsor should be communicating to the HCE's that they will need to include the excess distribution in their 1998 tax return. If the plan has done projected tests thoughout the 1998 plan year and thinks they may fail, even after communicating the need to cut back the deferrals of HCE's, then they should also prepare the HCE's for the inevitable, and tell them to hold off on filing their 1998 returns until after 3/15/99. In addition, the Plan Sponsor should issue a letter with each check to outline the tax consequences for the appropriate tax year impacted, in this case 1998. This is the only way the HCE's would know, since they won't actually receive the 1099R until early in 2000. Another alternative that most clients don't ordinarily consider initially is the option for the Plan to deliberately delay the return of excess distributions until after the 2 1/2 month timeframe (or after 3/15 for calendar year plans), but prior to the required 12 months following the end of the plan year being tested (after that there would be a qualification issue). Although the Plan Sponsor would have to pay a 10% penaly on the amount of the excess returns paid after 3/15, the distributions would be taxable in the year the check is issued rather than in the year for which they applied to the plan. HCE's would then be able to claim the taxable income on their CURRENT 1999 tax return which they would file by 4/15/2000. This would be a much easier message for a Benefits Director to deliver to the HCE's who are already upset that they are receiving an excess distribution. This could far out weigh the penalties imposed on the Plan Sponsor for making returns after 3/15. Of course you'd want an estimate of the excess returns in order to determine the severity of the penalty tax. But consider that if all excess returns amounted to $5,000, the Plan Sponsor would pay a penalty of $500 for correcting after 3/15. This may be well worth it to the company if the message they deliver to HCE's states that they can file the excess return as current income, rather than amend a prior year's return. Even more significant to consider is that the IRS considers the excess returns made PRIOR to the 2 1/2 months to be distributed on a FIFO method based on the plan year being tested. Meaning that the first contributions made in the plan year are considered to be the first to be returned to the HCE. Further, the excess returned would be taxable to the HCE in the tax year in which falls the first day of the plan year being tested. This is the basis for determining that excess distributions made prior to 3/15/99 for the calendar plan year 1/1/98-12/31/98, would be taxable in 1998, since 1/1/98 falls within the 1998 tax year. But suppose this is an off calendar plan, for example 12/1/97-11/30/98. If the Plan pays excess distributions within 2 1/2 months after the plan year end, or by 2/15/99, a check would be issued to the HCE in 1999, the 1099R would still be issued in early 2000, but the distribution would be taxable to the HCE in 1997 since the first day of the plan year falls in 1997 tax year!! The HCE would most certainly have to amend their taxes for 1997. This would be a pretty hard message for a Plan Sponsor to deliver. Of course if the Plan chooses to wait until after the 2 1/2 months and pay the penalty, this could be avoided. The HCE's would be issued their checks in 1999 and it would be taxable when paid. Definitely something to consider when consulting with your clients.

[Disco Stu]

I can't argue with anything that you have said. In the larger companies that I deal with, this takes place pretty regularly. Often, however (and this is Mike's point) in a small company there is no one there to explain to the HCEs what is going on. Many small company managers and execs have neither the time nor the inclination to learn all these goofy testing rules. I can't blame them too much for that. I give them the info that I have and hope that they make the best of it.

[Guest Ron]

I have also found that IRS publication 575, Pension and Annuity Income has a short explanation on how these items are taxable. It covers 402(g) excesses pretty well, and also touches on ADP refunds. It is available for download from the IRS website.

[Guest ANGELKIM]

Originally posted by pensiondoc

If an HCE has to take back money for the 98 year before 3/15/99, does he claim it as income in 98 or 99?  I know to give a 1099R for '99 so wouldn't he claim it as income in '99??

Is this still true in 2002?

Thanks,

Kim & Angel

[Disco Stu]

The rules regarding timing of refunds to fix failed ADP/ACP tests have not changed.