Refund check to participant, or business?

[Belgarath]

Acme Sports is a sole proprietorship. The John Q. Owner defers on a draw throughout the year. Contributes $24,000. After end of year, taxes get done, and it turns out he has zero earned income. So there's a 415 excess to be refunded. Should the check be made out to Acme Sports, or John Q. Owner, or does it not make any difference? Since he had no income from which to defer, it seems to me that it should go to Acme Sports - but then how does one report it on a 1099? Probably easier to refund directly to John Q. Owner, report on a 1099? With 10% withholding (unless he elects out of it)?

[Madison71]

My initial thought is to refund directly to John  Q so you can issue a 1099.  

[RatherBeGolfing]

It goes to John Q.  

[Belgarath]

I had another thought - why not treat it as a mistake of fact? I know, I know, mistake of fact is very limited, etc., etc. - but it seems reasonable that in a sole prop situation,  if a deferral amount is contributed based on an erroneous calculation of income, and it is subsequently discovered that there is no income, that it should qualify. Thoughts?

P.S. - it turns out that the vendor apparently already refunded to Acme Sports, rather than to John Q...trying to confirm if this is true...

[Bird]

I don't think it is a mistake of fact.  I think that is limited to mathematical or clerical errors.

I don't think it matter who gets the refund; a sole prop and individual are theoretically the same.  The 1099 should be in the name/SSN of the individual.

[RatherBeGolfing]

36 minutes ago, Bird said:

I don't think it is a mistake of fact.  I think that is limited to mathematical or clerical errors.

I don't think it matter who gets the refund; a sole prop and individual are theoretically the same.  The 1099 should be in the name/SSN of the individual.

I know some people on here will argue that it is a mistake of fact, with at least informal guidance saying it could be considered a mathematical error.  I have seen it posted here before.  I agree with you though, a change in circumstances is not a mathematical or clerical error to me.

[jpod]

And the 1099-R has to show zero as the amount taxable.  

[Larry Starr]

10 hours ago, Belgarath said:

Acme Sports is a sole proprietorship. The John Q. Owner defers on a draw throughout the year. Contributes $24,000. After end of year, taxes get done, and it turns out he has zero earned income. So there's a 415 excess to be refunded. Should the check be made out to Acme Sports, or John Q. Owner, or does it not make any difference? Since he had no income from which to defer, it seems to me that it should go to Acme Sports - but then how does one report it on a 1099? Probably easier to refund directly to John Q. Owner, report on a 1099? With 10% withholding (unless he elects out of it)?

There is absolutely no difference between the individual and Acme Sports.  They are one and the same legally so it makes no difference how the check is issued. My first thought is that there is NO 1099; the amount contributed is not deducted anywhere, but this is just a first impression without doing any research and maybe the answer is different.

[Luke Bailey]

I assume based on question that the $24,000 is all elective deferral and catch-up? This is obviously a mind-bender, because as a sole proprietor, the participant with the issue is also (and I mean "is" in the most direct, literal sense) the plan sponsor.

I actually don't know the right answer. If you treat it as a 415(c) violation under EPCRS, or perhaps even better, as a failure to follow terms of plan (since the plan document probably says to multiply his elected percentage times his self-employment income to determine his deferral amount, and that was not done), and you distribute to him and report on 1099-R with code E, IRS will treat that as gross income, right? But he will not be able to take a deduction on his schedule C to offset that, right, because in excess of 25% of comp (unless he has employees)?

Larry's answer is the most practical, but the money is in the trust, so unless they are comfortable leaving it there to fund future contributions, it needs to come out, and if paid back to sole proprietorship account without 1099-R, difficult for me to fit that into the mistake of fact rationale.

 

[Bird]

It's Monday morning and some knowledge may have leaked out, but I think if you have a 402(g) violation (forget about the sole proprietor for a minute; let's say someone put in $30,000 to two different plans), that you (the participant) have to claim the excess as income in the year deferred, and will get a 1099-R the following year that effectively says the money was refunded but not taxable in that following year (the year distributed).  For a sole proprietor, he simply doesn't take the deduction in the current year, and isn't taxed in the year the money is distributed.

[Luke Bailey]

Bird, I doubt this was a 402(g) issue, but it may be. Would be very helpful to know from original question what type of contributions involved and whether plan has any other participants.

[Belgarath]

It is not a 402(g) issue. Plan does have other participants.

The issue is less one of actual taxation (his Schedule C loss is such that even with the $24,000 refund, he'll still have a loss, so it isn't going to result in income tax anyway) than it is the mechanics of required reporting/withholding on the part of the plan.

If it had been deposited during 2018, this would all be easy - we'd just count it as a 2018 contribution and leave it in the plan, but it unfortunately was contributed in 2017. And just to confirm - the vendor did refund it to Acme Sports.

This is one of those things that we all obsess about ('cause that's what we do) that in real life makes no practical difference because in the situation at hand it isn't ultimately taxable anyway!

Thanks for all the feedback and discussion. I think I'll put this one to bed at this point.

[Tom Poje]

the closest you come is a statement in the preamble to the 401k regs (though it doesn't really say how to fix) I would read it as saying such amounts are not the participants since they would based on his earned income

The preamble to the 401(k) Regulations describes it as follows:

 

One commentator asked for clarification of the interaction between these timing rules and the rule under the regulations that treats a self-employed individual's earned income as being currently available on the last day of the individual's taxable year and whether this last day rule precludes a partner from making elective contributions during the year through a reduction in the partner's draw. The restriction on the timing of contributions is not intended to prevent a partner from deferring amounts that are paid to the partner throughout the year on account of services performed by the partner during the year, and the final regulations have been modified to clarify this point. However, self-employed individuals who take advantage of this opportunity to defer amounts during the year must make sure that the amount contributed during the year will not exceed the limits (such as the limits of section 415) that will apply to the individual, based on the individual's actual earned income for the relevant period.

[Bird]

2 hours ago, Belgarath said:

It is not a 402(g) issue. Plan does have other participants.

My mistake in saying "402(g)" - but I think it is an "excess deferral" for exceeding 100% of pay and my comments were meant for that definition.

Interesting fact that there are other participants.  If not well-documented that this was intended as a deferral contribution, it might be argued that it is profit sharing and should be allocated.

[Belgarath]

Hi Bird - FWIW, I think we'll just agree to disagree. From my myopic viewpoint, it can't possibly be an excess deferral, because there can be no "deferral" if there is zero income.

Just as an aside, it was properly documented that this was intended as a deferral. They just screwed up, and in the initial calculation of income, determined that there was income from which to defer. Then when numbers got finalized there was a "whoops."

Fun stuff..

[Tom Poje]

agree. let's suppose no deferrals were made during the year,  I look at my schedule C and it is negative. oh heck, I'm still going to put 20000 into the plan and then take a distribution because of 415 issues.

[Bird]

21 hours ago, Belgarath said:

Hi Bird - FWIW, I think we'll just agree to disagree. From my myopic viewpoint, it can't possibly be an excess deferral, because there can be no "deferral" if there is zero income.

More to make sure I'm not mis-thinking, would you feel differently if he deferred $18,000 and then had income of $10,000?  The extra $8,000 is still not any kind of deferral?

(Ironically, I just learned that I have a client who is facing this very situation for 2017...)