distribution overpayment

[Guest GENE]

I have a participant in a profit sharing plan who on termination of employment was paid 100% of their account balance when they were only 40% vested. Participant refuses to repay the difference. How should this be corrected?

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[david rigby]

You might do a search for this issue on the message boards.

The other plan participants have an interest in this, so the plan probably has an obligation to try to recover. Also, you might notify the individual that the balance is not a valid distribution, so not eligible for rollover.

[pjkoehler]

The employer could reimburse the plan for the loss and bring a collection against the terminated employee on a subrogation theory. If the former employee is judgment proof, then the employer may choose to make a business decision not to pursue it. Of course, the miscalculation of the vested interest could form the basis for a claim against the responsible fiduciary. That fiduciary (board of directors, administrative committee, head of HR, etc.) is probably indemnified by the employer, so the employer's assets are probably ultimately exposed. If it turns out that a contract administrator was responsible, you might pursue a claim against the company's E&O insurance carrier, assuming that it is insured (which many of the thinly capitalized operations, of course, aren't). If the contract administrator was responsible, but doesn't have E&O insurance, the employer could bring its own breach of fiduciary duty claim, but it will have a tough row to hoe, trying to show that the administrator was a fiduciary. It could also bring a plain old breach of contract suit, but if the amount of money involved is small, you're probably better off trying to reach some other business arrangment with the administrator, or chalk it up to experience and fire the firm.

[This message has been edited by PJK (edited 05-02-2000).]

[Kirk Maldonado]

Don't forget that the distributee should get a 1099-R for the full amount of the distribution, at least if the distributee does not repay the unvested portion.

[david rigby]

Kirk,

should the 1099-R be for the full amount, or should it be for the correct amount, with some other form (1099-Misc ?) for the balance?

[Kirk Maldonado]

I can't really respond authoritatively to that question, other than to say that my prior answer should have been that the 1099-R should be limited to the correct amount. Thus, if the participant rolled over the entire distribution to an IRA, the participant most likely made an excess contribution. I don't know how the excess amount should be reported.

[pjkoehler]

I think Kirk had it right the first time, i.e. the plan should report the entire distribution. The instructions to Form 1099R require the plan admininstrator to file the form for each recipient of a "designated distribution." A "designated distribution" is "any distribution or payment from or under an employer deferred compensation plan . . ." Code Sec. 3405(e)(1)(A). Reg. 35.3405-1, Q&A-2. There is no exception for unintentional distributions or distributions due to a mistake in fact or a mistake in computation. Keep in mind Form 1099R is used to report both eligible and noneligible rollover distributions, periodic and nonperiodic, so it's a stretch to infer that the form ignores certain plan distributions. The only exceptions are distributions treated as "wages" and any portion of a distribution that it is "reasonable to believe is not includible in the gross income of the payee." Logically, to preserve the symmetry between the amount of the distribution and the employee's 1040, the form should report the entire amount, unless the excess portion is treated as wages and reported on a W-2, which seems anomolous since its a distribution from a qualified plan on termination of employment. The better approach would be to report the entire amount on 1099R at the end of the year, unless the participant has repaid the excess. If the plan recovers the amount from the participant in a subsequent taxable year, it can file a corrected 1099R for the prior year at that time.

[david rigby]

quote:

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Originally posted by PJK:

There is no exception for unintentional distributions or distributions due to a mistake in fact or a mistake in computation. ...

... unless the excess portion is treated as wages and reported on a W-2, which seems anomolous since its a distribution from a qualified plan on termination of employment.

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Pardon my pickiness.

1. It seems silly to say that because the 1099R instructions don't address a mistake, then the entire payment should be treated as a distribution from the plan.

2. It does seem appropriate to report the entire amount (assuming excess not repaid) but that should not mean that it is all eligible for a rollover. Seems to me that if the sponsor has determined that a portion is not eligible, then the sponsor has the obligation to report it correctly, even if that means filing amended 1099. Seems that the IRS would want the sponsor to get it right, even if correction is required.

Am I beating a dead horse?

[pjkoehler]

I don't think it's a question of "pickiness," it's a question of reading something into the instructions to Form 1099R that isn't there. The "Specific Instructions" section provides: "if part of the distribution is taxable and part is nontaxable, file form 1099R reporting the entire distribution." This would on its face cover situations in which part of the distribution is an eligible rollover distribution, reported as a direct rollover (nontaxable) and part of it is not an eligible rollover distribution, e.g. a distribution covered by Code section 401(a)(9) (taxable). While an overpayment has more complex ramifications than the payment of other forms of taxable distributions, this seems utterly irrelevant to the reporting requirement itself. The overpayment happened; it's includible in the participant's gross income unless he give it back by the end of the taxable year of the distribution; it's doesn't fall under any of the express exceptions to the definition of a "designated distribution;" and, on the basis of a purely functional analysis, the failure to report such amounts on 1099R would interfere with the ability of the IRS to perform its routine data match of linked returns.

[Guest GENE]

i am more interested in how to correct the forfeitures due the remaing plan participant's since the i reported the entire

distribution amount on form 1099R. any guidance?

[pjkoehler]

There's a couple of approaches here. First, as a legal matter, the recipient is indebted to the plan to the extent of the overpayment and the financial accounting should reflect this,i.e. debit "benefit payment expense" and credit a temporary asset account, call it "overpayment receivable." The two entries wash as a financial reporting matter and you should allocate the forfeitures normally arising without regard to the impact of the overpayment on the cash account. Presumably, the plan has sufficient liquid assets to pay benefits as they come due, so you could take this position for multiple plan years. Sometime before the expiration the IRS's "self-correction" period, the employer should decide whether or not to make a corrective contribution equal to the overpayment plus earnings. If it takes this approach, then debit "overpayment receivable" and credit cash. If not, then the trustee should write off asset as a "bad debt" loss: debit asset account "overpayment receivable" and credit "bad debt loss" expense. If you follow the latter approach, the trust ends up absorbing the overpayment as part of net investment earnings in the year of the write off. This can be challenged on a variety of theories, not the least of which is that it fails to achieve a basic requirement of "self-correction," viz. putting the plan in the position that it would have been in but for the overpayment. So, the best advice is that after exhausting all reasonable legal steps to recover the overpayment, have the employer make the necessary corrective contribution.

[This message has been edited by PJK (edited 05-12-2000).]

[This message has been edited by PJK (edited 05-12-2000).]

[Fredman]

If you are reporting the entire distribution on a 1099-R what distribution code are you using?

Here's an interesting way that I've seen:

1. Report the amount the participant should've received on 1099-R.

2. Report the overpayment on 1099-MISC (showing as all taxable). If the overpayment is less than $600, don't report it.

Regardless of the amount of the overpayment or how its reported the overpayment is taxable income to the participant. The 1099-MISC helps with keeping the participant honest with the IRS and sometimes will help with the recovery of the overpayment.

Lastly, the plan needs to make whole and it should be done as soon as possible. Someone needs to fork over the money to be put back into the plan and then they can bicker over who owes who what.

[pjkoehler]

The codes applicable to Box 7 of Form 1099R recognize distribution events that result in unique tax consequences. It can be argued that the code is based on the facts as the admininstrator understood them at the time of the distribution. Accordingly, for example, a distribution due to death should be coded "4" (Death), even though the plan administrator subsequently determined that it overpaid the deceased employee's beneficiary.

In the period prior to the filing deadline, the plan administrator could take the position that the overpayment represents a loan by the plan to the beneficiary and not a distribution, but ultimately, if not repaid, as practical matter it's a "distribution" from the plan. The only category of "miscellaneous income" that is not expressly inapplicable under the instructions to Form 1099-MISC is "other income of $600 or more." The argument for using 1099-MISC, doesn't explain why bona fide plan distributions of less than $600 must be reported on 1099R, but overpayments of less than $600, which are just as includible in the recipient's gross income, for some reason escape reporting, because we switch to 1099-MISC. Only the use of 1099R avoids this anamoly.

Consider, in the above death benefit example, if the administrator finds out that the employee isn't really dead. Does it file a corrected 1099R reporting zero death benefit distribution, and a 1099-MISC reporting the distribution as "other income?" What if the account balance is less than $600. It seems like a stretch to say that the Service is more concerned with accuracy in coding the form than in reporting the actual amount includible in the recipient's gross income.

[This message has been edited by PJK (edited 05-12-2000).]

[This message has been edited by PJK (edited 05-12-2000).]

[This message has been edited by PJK (edited 05-14-2000).]