Inclusion of ineligible employee

[John A]

What is the correction when an ineligible employee of a single-employer with a 401(k) profit sharing plan is allowed to make 401(k)contributions and receives matching contributions? What must happen to the deferrals, interest on the deferrals, matchin contributions, and interest on the match? Can an IRS self-correction program be used? If so, which one? Can any money be returned as "mistake of fact" if the plan has the proper language? What would constitute a "mistake of fact"? When would the one-year period start? Would any of the answers change based on how long the ineligible employee had been allowed to make 401(k) contributions and get the match (3 months vs. 2 years)?

[Guest boetgerinc]

I am not sure of the answers to all of your questions, I just wanted you to know that we have a plan under IRS audit that allowed inelligible employees into their plan. (The plan was amended for immediate eligibility, but the plan 's entry dates were never changed from 1/1 & 7/1). There is a letter to the Trustee in the file, from the recordkeeper, stating this happened. The Trustee responded that it was an oversight that the entry dates were not changed, and the company intended immediate eligibility for all.

The IRS did not acknowledge the correspondence and threatened plan disqualification for not following the terms of the plan. Now their proposal is to return deferrals to employees, who then have to file amended tax returns, return match and profit sharing to employer, who would also have to file amended returns, and also pay a penalty to the IRS. The IRS has not addressed earnings (leave in plan and allocate to others or take out).

My point is that this is a potentially serious offense (more serious than excluding an elligible employees, which can be corrected under Standardized VCR).

[Guest amm]

The defect posed in the questioner's scenerio is not "more serious than" excluding someone from the plan when he or she is eligible. Both situations constitute a qualification defect. Both situations could be corrected under VCR, but once a plan is under an IRS audit any qualification issue that is discovered by the IRS cannot be rectified by VCR. Audit CAP or APRSC would be the programs available to correct the defects once the plan is under audit. The IRS would tell you which program they feel is appropriate.

In answer to the original question: All deferrals, including interest earned on those deferrals, must be returned to the employee. All matching contributions, plus earnings on the contributions, must be forfeited. In all situations, an analysis must be made before you can determine which correction program (Walk in CAP, VCR or APCRS)is appropriate. The time frame involved is only one aspect of the analysis.

The situation you describe does not constitute a "mistake of fact". This term is only applied in very limited circumstances. In almost all situations, you would probably be better off if you just "forget" that the term "mistake of fact" even exists until you have had a chance to research the proper usage.