Ineligible employee and governmental pick up

[JJRetirement]

Client is a municipal plan who recently discovered that a few employees who should have been excluded has been making employee contributions. One employee has been erroneously included for about 15 years and the others for less time. Mandatory employee contributions have been picked up by the employer since 2003 and were after tax prior to that.

Note: This is not an early entry of an otherwise eligible employee - this employee would never become eligible for this plan.

Can the plan distribute the contributions to the employee to correct? Can this be done under SCP (assuming insignificant failure) or would a VCP application be required? Would the distribution be taxable in the year distributed as an excess amount or be taxable in the year in which each contribution was made?

I am not aware of any formal guidance that addresses this issue specifically. However, I have read the transcript of an IRS phone forum from 2/21/13 on EPCRS changes and the last question asks what should be done with 401(k) deferrals for a participant who was not eligible. Janet Mark stated that the deferrals should not be forfeited and should not be treated as excess amounts, but should be distributed back to the employee and the employee would take that dollar amount into his taxable income. Further, this might required that the participant file an amended tax return to take into account the deferrals.

This situation seems to be analogous - so would a participant have to re-file 15 years' worth of tax returns in order for the plan to make this correction?

Any thoughts are appreciated!