Correction of ineligible Hardship Distribution

[Bruddah Kimo]

I have a calendar year Plan that processed a hardship distribution for a participant in 2011. While undergoing an audit for 2011 it was found it did not qualify. The plan uses safe harbor hardship definitions, one of which is 'payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the Participant, and the Participant's spouse, children, or dependents (as defined in Code §152, and without regard to Code §152(b)(1), (b)(2) and (d)(1)(B));'. While Sponsor approved the hardship request to be processed the auditor found that the hardship was used to payoff outstanding school loans. He is asking what corrective steps need to be taken. Has anyone had experience with a similar occurence? The IRS Fix-It Guide states that 'have participant return hardship distribution amount plus earnings' but this leaves unanswered questions:

1) How to detemine the 'earnings'

2) How to handle tax reporting for 2011 distribution. Amend 1099-R(?)

3) Can it be self-corrected in another manner (reclassifiy as a loan possibly?)

Any comments or insights on handling this situation would be appreciated! Thank you!

[Kevin C]

The EPCRS correction method for overpayments from DC plans is in Rev. Proc. 2008-50, Section 6.06(3).

(3) Correction of Overpayment failures. An Overpayment from a defined benefit plan is corrected in accordance with the rules in section 2.04(1) of Appendix B. An Overpayment from a defined contribution plan is corrected in accordance with the Return of Overpayment method set forth in this paragraph. Under this method, the employer takes reasonable steps to have the Overpayment, plus appropriate interest from the date of the distribution to the date of the repayment, returned by the participant or beneficiary to the plan. To the extent the amount returned to a defined contribution plan is less than the Overpayment adjusted for earnings at the plan's earnings rate, then the employer or another person must contribute the difference to the plan. The Overpayment, adjusted for earnings at the plan's earnings rate to the date of the repayment, is to be placed in an unallocated account, as described in section 6.06(2), to be used to reduce employer contributions (other than elective deferrals) in the current year and succeeding year(s) (or if the amount would have been allocated to other eligible employees who were in the plan for the year of the failure if the failure had not occurred, then that amount is reallocated to the other eligible employees in accordance with the plan's allocation formula). In addition, the employer must notify the employee that the Overpayment was not eligible for favorable tax treatment accorded to distributions from Qualified Plans (and, specifically, was not eligible for tax-free rollover).

If the employer is making a contribution for this year, the correction when the employee will not return the excess is painless. The overpayment, plus interest is deposited and used towards the employer contribution for the year. The Rev. Proc. has methods for calculating lost income, including some in the exceptions to full correction section 6.02(5).

I don't know about the 1099R, but think you wouldn't amend unless the participant repaid the distribution.

I don't see how you could reclassify this as a loan, even if it was possible. One of the requirements for a SH hardship is that the participant max out on available loans first. So, how can he have another loan? Even if you could, the retroactive loan would already be in default and beyond the maximum cure period. The only way to fix the tax consequences of the deemed loan would be a VCP filing. To me, that would be a bigger mess than what you started with. I think you are much better off using the EPCRS correction from above.

[TPAMan]

If this is a QCPA audit, I wouldn't think that the auditor would have the authority to disqualify a SH Hardship distribution after the fact. He/she could recommend a change in SH Hardship determination procedures for the plan...

[Bruddah Kimo]

Thank you Kevin - I should have mentioned that this is a DC plan. No further contributions are to be made for 2011, they only make EE Deferrals & ER Match.

You're right about the loan option, I was trying to get creative and overlooked the fact the participant had already taken out available loans.

[Kevin C]

The overpayment would not have been allocated to other participants if the failure had not occurred, so the corrective deposit will go towards 2012 employer contributions. If they are still matching for 2012, it should still work.

[masteff]

the auditor found that the hardship was used to payoff outstanding school loans.

Just to clarify your exact meaning... it doesn't matter what the money "was used for", rather what matters is the paperwork that the participant submitted when applying for the hardship. Was the paperwork to payoff an outstanding loan or for properly allowable education expenses? What is in the file? If you have proper documentation on file, once the money is out of the plan, it's between the participant and the IRS.

Also, check w/ the participant to verify if absolutely no allowable education expenses were paid in the following 12 months. Money is fungible. So if the participant did pay allowable expenses then it doesn't matter if they also paid down an outstanding loan.