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Correction of Pick-up - ineligible employee


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I posted this issue in EPCRS and didn't get a response so I'm trying again here.

Governmental employer with a defined benefit plan that includes mandatory employee contributions picked up by the employer.

Handful of employees in an excluded class have been erroneously treated as eligible and pick-up contributions have been made for them for many years. How can we correct?

(The employer will need to pay social security taxes for these employees, so we don't want to do a retro amendment to include them in the plan. This would also require a VCP since this isn't early inclusion of otherwise eligible employees)


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This is not one of the issues covered in the example corrections, so any corrections method would have to be cleared with the IRS on filing of the VCP submission. Thus, you are not going to get a definitive answer. However, I can think of a couple of possible corrections methods you could consider.

The first method is based on the fact that in general, picked up contributions are treated as employer contributions. The pickup rules were originally adopted to reflect the fact that a private employer could simply make a nondiscretionary employer contribution to a plan (and calculate the wages it was willing to pay by taking into account the contributions made), and thereby cause the contribution to be pretax. However, a governmental employer was often subject to the terms of a statewide plan that called for a particular level of mandatory employee contributions, and had no ability to modify the plan to eliminate such contributions and substitute nondiscretionary employer contributions. The pick-up rules allowed a governmental employer by resolution to redefine mandatory employee contributions as nondiscretionary employer contributions, and thus to achieve the result a private employer could have obtained by amending the plan. (It is for this reason that pick-ups are limited to governmental employers.)

If we treat a pick-up as a nondiscretionary employer contribution, it would seem that the appropriate correction method would be to treat the employees as having been improperly included in the plan, or as having received contributions in excess of those permitted by the terms of the plan. In either event, the picked up contributions to the plan would be treated as employer contributions, and would be forfeited by the employee. (The forfeitures could be used to reduce future employer contributions to the plan.) To the extent that employees' wages were erroneously reduced to reflect the erroneous contributions, the employer should be paying back wages to the employee equal to the erroneously made contributions plus interest thereon.

Alternatively, the picked up contributions might be treated under the rules applicable to erroneous 401(k) contributions. In this case, the excess contributions would be returned directly to the employee, with earnings, and include a written notice explaining the refund is taxable and not eligible for rollover.

As a theoretical matter, I think the first approach is better, because it reflects the fact that the contributions were not discretionary with the employee. However, I don't know that the IRS would care about the theory all that much so long as the result was equitable.

The net effect of either of these methods is similar. The employee gets the same amount back. The difference is whether the amount comes from the plan or from the employer. But even if it comes from the employer, the employer can get a corresponding reduction in future contributions. And Social Security should not be owed on the back wages under the first approach, because you have said that Social Security was already paid when the contributions were made.

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