Ineligible employee makes elective deferrals

[jkharvey]

Ineligible employee is allowed to make elective deferrals. I know this has been addressed before, but I'd like to know the most recent position. I saw postings that said the IRS would not consider this to be a "distributable event" and the money should be returned to the employee outside of the plan and then the deferrals forfeited. The Q&A portion of this site, Question 141-143, seems to indicate that these deferrals can in fact be distributed from the plan to the participant. What is the IRS' current position?

[Steve72]

I've not yet read through the whole thing, but example 22 in Rev.Proc. 2001-17 seems to say that you can self-correct this issue by adopting a retroactive amendment.

[Wessex]

But in the example, all employees were allowed to enroll before they were eligible, and the amendment would cover all employees and would have no effective availability issues. This seems an unworkable solution in the more common case where just one or a few ineligible employees are inadvertently covered. It could be very expensive to make contributions for all new employees, and presumably QNCs would have to be made in a 401(k) plan as those employees who were not erroneously allowed to participate could not make retroactive deferrals.

Although it is by no means crystal clear, I am still of the view that the EPRSC guidance provides for distribution of deferrals despite the Service's informal change in position last year. See Section 5.01(3)(h), the second sentence of Section 6.02©, and the fourth sentence of Section 6.05(1) of Rev. Proc. 2001-17.

[Guest JBeck]

Can someone provide me with the details of the correction if an ineligible participant made elective deferrals for 1997, 1998, and 1999, and received a matching contributon for such years? I believe that the salary deferral account (including earnings) should be distributed to the participant. How should he be taxed? Should revised W-2s for the amount of the deferrals made for 1997, 1998 and 1999 be issued for 1997, 1998 and 1999? Should 1099-Rs be issued for the earnings for such years? Should additional withholding be taken out for amounts that are included on the W-2s and sent to the IRS? Can the withholding just happen to equal the employee's incremental tax rate so that if he or she does not refile, it isn't a big deal? Would the match have to be forfeited? In this case the plan is a safe harbor plan so that the plan does not indicate what to do with forfeitures (everyone is 100% vested). There does not appear to be much guidance on this and your thoughts are appreciated.

[KJohnson]

WESSEX, what was the "Service's informal change in position last year?" I always thought that return of the deferrals and forfeiture of the match was how they wanted this corrected.

Also, as to correction by amendment, could you somehow structure your plan amendment to just describe the employees who were erroneously made eligible. Section 2.07(3) of Appendix B is silent on the treatment of "simlarly situated" employees who were properly excluded from participation.

For example in one month you let three employees in one department participate on their date of hire. I wonder what the Service would think of an amendment like...."Employees in job category X whose first Hour of Service was in Month Y shall participate upon their first Hour of Service?"

To use correction by amendment the employees affected must be "predominantly nonhighly compensated" in any event, so I am not sure what other problems such an amendment would create

[John A]

jkharvey,

I do not think the IRS has ever stated a position on this issue, other than the amendment solution in Rev. Proc. 2000-17. I still like the Wessex answer above the best but believe it carries more risk (although perhaps very little more) than the option of keeping the money in the plan and making the participant whole outside the plan. The IRS had a great opportunity to make this crystal clear in Rev. Proc. 2000-17 and chose not to address the issue.

If distributing from the plan to the ineligible employee is chosen, it begs several questions: 1) Should gains on the deferrals be distributed also? 2) What should be distributed if there have been losses on the deferrals? 3)Should a 1099-R be done to report the distribution, or how should the distribution be reported? 4)If the distribution is reported on a 1099-R, what code or codes should be used? 5) Is any adjustment to a W-2 necessary? 6) Is the plan risking disqualification by distributing plan assets to non-participants when there is no official guidance that clearly provides for this correction (although I like Wessex's cites above)?

The option of correcting outside the plan and forfeiting the "deferrals" seems to be a safer but less appealing option, and it also begs questions, such as 1) does any W-2 need to be adjusted under this option (presumably yes, since the W-2 should be corrected to be sure it does not show the amounts contributed as deferrals), 2) how does the payment outside the plan get reported (ordinary income on the W-2, some other type of income)?

I believe there are very strong arguments for and against both options, but the majority opinion seems to be to distribute the "deferrals."

The IRS has not stated an official position. And I believe prior threads have stated that the IRS offered differing opinions in 2 different ASPA meetings.

I am very disappointed that the IRS did not use Rev. Proc. 2000-17 to end this debate!