Ineligible Compensation used for Deferrals

[JustMe]

We have a client that withheld deferrals on severance pay over the past several years.  The participants have all taken distributions from the plan and most rolled their funds to another qualified plan or IRA.  We are currently working on a VCP submission for the client for all other plan issues.  For this issue, I believe the correct method is to issue two corrected Form 1099-Rs for the year of the distribution: 1 for the ineligible deferral amount and 1 for the updated distribution amount eligible for rollover; and notify the participant of the issue and that the funds were not eligible for rollover. 

Any thoughts on other corrective methods to pose to the IRS since we are going through VCP anyway?  Suggest the participant will be taxed on the distribution anyway when the funds are distributed from the plan/IRA, so avoid double taxation and not issue the corrected 1099-R that may not prompt a "tax-free" distribution from the rollover IRA/qualified plan??

Any suggestions/insight with personal experience on this particular issue would be greatly appreciated!

[Luke Bailey]

JustMe I think what you describe in first paragraph is only correction IRS will give you. Since problem goes back more than two years, apparently, should include this in VCP unless you believe number of participants and dollar amounts sufficiently small that error "insignificant."

[hr for me]

Agree with Luke......it's going to depend on the dollar amounts. I've been able to argue sufficiently small while under audit and only had to correct a few deferrals/match/PS/SafeHarbor on the incorrect pay definition (ours was Overtime, which got pretty significant for a few employees, but they were NHCEs).    So the question is how big is the error?  

[Kevin C]

If the amounts are too large to use the exception to full correction for small amounts,  I think I would try something other than the correction method spelled out in the rev. proc.   Section 6.02(2) says that other correction methods may be reasonable and appropriate.  6.02(5) at least implies that corrections should not have significant adverse effects on participants and beneficiaries.  I would consider retroactively increasing participants taxable income for a prior year when they have already filed their tax return to result in significant adverse effects.  While it isn't your exact situation, I think I would try proposing correction using the method specified for correcting an Excess Amount in 6.09 (5)(b).

Quote

(b) As part of the proposed correction for Excess Amounts, the recipient removes the Excess Amount (adjusted for Earnings) from the recipient's 403(b) Plan or IRA and reports that amount (reduced by any applicable after-tax employee contribution) as a taxable distribution for the year in which the Excess Amount (adjusted for Earnings) is removed from the recipient's 403(b) Plan or IRA. The amount removed is generally taxed in a manner that is similar to the manner in which the corrective disbursement of elective deferrals is taxed, as described in section 3 of Rev. Proc. 92-93.

You are already filing under VCP.  It doesn't hurt to ask.

[JustMe]

Thank you all for your responses.  Kevin C - that was my thought exactly.  If we're filing under VCP, it doesn't hurt to ask for an alternative corrective option.  

Thank you again!