Net vs. Gross Repayment of Overpayment

[Gruegen]

A participant received a distribution of his entire $10,000 account balance on September 1, 2011 which was not rolled over. As such, the participant received a $8,000 check and $2,000 was withheld for federal income tax withholding purposes. The original reason for the distribution was on account of termination of employment. A 2011 Form 1099-R was properly prepared to report this distribution and the federal tax was withheld and remitted to the IRS.

However, in February, 2012, it was determined that the participant did not have a termination of employment in 2011 (just a change of divisions). Under Section 5.01(3)© of Revenue Procedure 2008-50, it appears that the correction method would be to take reasonable steps to have the amount returned by the participant to the Plan. My question is....what is the amount that the participant should repay to the plan? $8,000 or $10,000?

1) If the participant repays the full $10,000 to the plan, how is the $2,000 of federal tax withholding treated since that $2,000 has already been remitted to the Treasury - - is it just "extra" federal tax withholding that is considered/counted when the participant completes his 2011 Form 1040? Further, is it "fair" to ask the participant to repay more than what the participant received in hand?

2) If the participant only repays $8,000 to the plan, would the IRS consider the error to be corrected even though the participant's account has not been put in the same position as if the error hadn't occurred?

I am assuming under either scenario that the 2011 Form 1099-R would need to be amended to reflect a lesser taxable distribution.

[pmacduff]

You have to remember that the participant did "receive" the $2000; it was just paid to the IRS as withholding. The participant will receive credit for that amount in the total taxes he/she paid for the year (your item (1) - the "extra" withholding). No different than the tax withholdiing done on someone's regular payroll the goes the IRS; i.e. you don't "receive" those $$$, but they are paid to the IRS on your behalf.

So...that being said - I think the whole $10,000 needs to be returned to the Plan.

Not 100% sure of the 1099-R correction, but you can find most of these types of situations (corrections) in the 1099-R instructions and/or the General 1099 instructions.

my two cents.