Taxation of Restoration Payments to Have Forfeitures Restored

Participant X is a participant in A's profit-sharing plan. After completing a few years of service, X quits when he is 40% vested and takes a distribution of his vested account balance. For simplicity's sake, let's say that the X's account balance is $10,000 and that his vested portion is $4,000. A's profit-sharing plan provides for the immediate forfeiture of the non-vested account balance upon distribution of the vested portion, subject to a repayment provision. Two years later, A rehires X. Let's say that X repays his $4,000 distribution and has the previously forfeited $6,000 portion restored. A few years later, X terminates his employment with A and receives a distribution of his fully vested account balance, which was then $20,000.

A couple of questions: (1) in the year when X repaid the $4,000 to A's profit sharing plan, was the repayment made with after-tax money or was it made with pre-tax money? Was the repayment amount treated as a rollover? (2) when X took a distribution of his then fully vested account balance, was the taxable portion limited to $16,000 or was it the full $20,000?

I believe the answers are (1) after-tax (unless it came from a an IRA or another plan, which should have been communicated at the time) and not a rollover; and (2) if after-tax, that $4,000 should have been treated as basis and the taxable portion limited to $16,000.

CuseFan,

I agree with your answer to (1). If we are dealing with a plain vanilla profit sharing plan with no deferrals or after-tax contributions, I believe that the amount is treated as if it were an employer contribution and subject to tax at distribution. Unfair? Definitely, but I believe it is one area where the recovery of tax basis rule falls apart. By contrast with qualified disaster distributions and qualified birth and adoption distributions, timely repayments effective wipe out the earlier taxation of the initial distribution. Not that restoration repayments may be made up to five years from the date that the employee is rehired. This might be one area for correction via a SECURE 3.0 or SECURE 2.5.

What authority do you have to to treat it as an Employer Contribution subject to taxation at withdrawal an not as After-Tax basis? Just because it's easier for the Plan to do so, does not mean that is the correct way to treat it.

Nothing specific. I agree that it would be not only fairer but consistent with the principal that you should not be taxed on amounts you contributed with after-tax dollars. Since the restored amount is an employer contribution that was previously distributied to the participant, then it might be argued that it should be treated and taxed as an employer contribution upon ultimate distribution.

Whether it is an employee or an employer contribution has no bearing on whether or not the employee can have basis in the account.

An employee can have basis in employer contributions. For example, if they took a loan which was deemed and later repaid.

The employee would not be taxed on the amount of basis upon distribution. Again, this is true regardless of whether it was employee or employer contributions.

The follow Q&A on this topic is from the American Bar Association Section of Taxation - May Meeting in 2004.  Basically, whether the forfeiture buy-back creates basis can depend on the source of funds that were used for the buy-back.

36. Sec.411(a)(7)(C)-Buy-back of Cash out Distribution

Section 411(a)(7)(C) provides that the accrued benefit of an employee that is disregarded by the plan must be restored upon repayment to the plan by the employee of the full amount of the distribution. Employee A participated in Employer's qualified defined benefit pension plan, terminated employment, received a lump sum distribution of the present value of his normal retirement benefit and rolled over his lump sum distribution from the plan into an IRA. The lump sum distribution did not include the value of any early retirement subsidies. Employee A was rehired by Employer and would like to repay the Employer's defined benefit plan the full amount of the distribution with pre-tax IRA funds. The repayment will be part of the Employer's defined benefit pension plan trust and will not be segregated in a separate account in the name of Employee A. May the Employer's defined benefit pension plan accept pre-tax funds from Employee A's IRA as repayment and include the repayment as part the trust's general assets? Does the answer vary if the amounts in the IRA are not funds from a tax-qualified plan distribution? Is the repayment from Employee A's IRA to the Employer's tax-qualified defined benefit plan a taxable event to Employee A?

Proposed Response: Employer's defined benefit pension plan may accept the pre-tax funds from Employee A's IRA as repayment of the prior distribution and include such amounts as part of the trust fund's assets. The repayment provisions of Sec.411(a)(7)(C) and Treas. Reg. 1.411(a)-7(d) do not state that only after-tax funds may be used to repay a pension plan and does not require that the repaid amounts be specifically set aside in a separate account for the participant. The answer is the same whether or not the pre-tax funds in the IRA originated from a tax-qualified plan. The amounts repaid by Employee A from his IRA to Employer's defined benefit pension plan will not result in ordinary income to Employee A because the amount is not distributed to Employee A.

IRS Response: The IRS agrees with the proposed response. It doesn't matter whether the buy-back is made with pre- or post-tax funds. The source of the money used for the buy-back is not important, but buying back a benefit with after-tax funds may create basis in the benefit for the participant. The source of the funds might be relevant to whether lump sum distribution treatment is available for the ultimate distribution from the qualified plan.