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Is the calculation method used for correcting the failed test incompatible with the test failed?


dragondon

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A plan ran APD testing for plan year 2023 and found that the plan would not pass the ADP test. On march 15th 2024 the plan used the leveling calculation method to determine a refund amount. Then the plan made a benefit correction for this amount which corrected the W2 to reflect the amount added back to their taxable wages. The plan then sent a 1099 R with distribution code 8 for just the earnings since the other amount was processed through payroll. 

Should the following have been done to correct the failure instead: 
Prior to March 15th correct the deferrals of HCE's to ensure that the ADP test was passed rather then provide an amount using the leveling method?

If an amount was provided via the leveling method should that amount have been taxed in the year 2024 rather then added back to their 2023 W2? 

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No, if you rig the W-2s you've literally changed the numbers for the actual test, and those withdrawals would have been operational defects if the amounts would not have been the same refund amounts from a test with the new deferral numbers.

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The perceived clever idea of adjusting W-2's to recognize the amount of a refund (made on or before March 15) as taxable income in the prior year is enticing since it appears to remedy the test failure, but this is not a permissible remedy.  First, keep in mind that someone getting a refund due to an ADP test failure is going to be an HCE.

For HCEs, all deferrals made during the year count in the numerator of the individual's ADP.  Making a refund doesn't change that amount, and neither will changing the W-2 but also to reduce the deferrals reported in Box 12 of the W-2.

When it comes to HCE deferrals, if they are in the plan, they are in the plan.  And, once they are in the plan the correction is made from within the plan.  Just playing with the W-2s does not change the fact that money for the deferrals was deposited into the plan, and money for the refunded deferrals (and associated income) should come out of the plan. 

You may want to have a heart-to-heart talk with the plan sponsor about cleaning this up.  They should issue correct W-2's showing correct income and deferrals.  (Hopefully, the participants have not yet filed their personal income taxes.)  They should issue refunds from the plan, and bite the bullet and pay the excise taxes.  They should make sure the refunded amounts are reported for the proper year(s) on Form 1099R along with the proper distribution codes.  They should make sure that were no adjustments associated with this clever idea that were made to current year W-2 data.  They should make sure that refunds are properly reported on the Form 5500/5500SF as corrective distributions.  They should consider taking steps that may be available under the plan to reduce the likelihood of the current failing the ADP test.

 

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Hypothetically lets say that instead of doing what they did they refunded the HCE prior to March 15th 2023 from plan assets in the amount determined using the leveling method amount. Then they provided a 1099R for the refunded amount and the earnings amount that were both taxed in the current year. In that case there would be no need to pay excise tax is that correct? And would that have been the correct corrective action that should have taken place? 

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If the refund was made prior to 3/15 but the earnings were not distributed until mid March does the company need to pay excise tax on the earnings amount or is excise tax only on the principal amount? 

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