Treatment of non-deductible contributions

A plan sponsor starts a plan and makes contributions which turn out to be non-deductible because they turn out to have no earned income.  This goes on for two years.

Year three and four, they have earned income and can deduct part of the contributions made.

IRS audit of personal and business returns results in denial of deduction for years one and two.  The letter arrives in year five. 

How do you determine the refunds, given that the non-deductible amounts have now earned substantial investment returns in the trust?  Do you attribute interest to the non-deductible funds?  How and where would that interest be reflected?

a. One theory is that the funds were invested in a trust that was not tax exempt during the first two years, so the trust should file taxes for that period only.

b. Another theory is that the trust was tax exempt in intent and did hold tax-deferred assets.  So the non-deductible contributions are the only amounts refunded.

c. Another theory is that the refund includes income attributed to the non-deductible portion and should be refunded as well, and treated as taxable investment return.

Since the IRS denial of deduction letter does not instruct how this is to be treated, I look for opinions and precedents.

They have only audited the returns and not the plan?  You could claim mistake in fact in that the IRS has denied the deduction for lack of earned income.  I would think b. or maybe c. - whichever one results in tax-exempt in intent and non-deductible contribution plus earnings are refunded.  I believe if have only losses then refund the non-deductible contributions only without factoring in the losses.

I don't understand.  You aren't very clear on type of plan and type of contributions. 

If this is a DC plan and the non-deductible contributions are Discretionary Employer Contributions then why would there be any refunds? 

If this is a DB plan I don't know enough to opine. 

But if a DC plan....

Wouldn't the correct result be simply to keep paying excise taxes until they can be deducted? 

I have to admit I am not sure how one allocates this money since there was no compensation. 

Or the theory this money ought to have been refunded as a type of excess Annual Addition?  If so, why wasn't that done back shortly after the plan year ended?

Maybe I am not understanding here but I don't see why there are refunds.  I see plenty of problems and a big mess but refunds aren't part of it. 

Happy to be told I am wrong so ignore me if you think I am way off base. 

I am working with Bob (soCalActuary) on this and can explain a little more.

This was an LLC that had both DB and 401k Plans. The sole owner was paid on a W2, which is what  probably triggered the audit at business level. IRS denied the W2 compensation and therefore also denied the deduction for the 401k deferral and DB contribution for years 1 and 2.  As to what happens to contributions made, no guidance was provided. Just a simple denial of deduction.

By year 3 and 4, LLC had elected to be taxed as S corp and things were fine.

We will be amending year 1 and 2 Form 5500 for each plan.

No contributions made in year 5. The client wishes to terminate both plans in year 6.

The question is what happens to the earnings on contributions from year 1 and 2 and brought forward to the time of termination. The denied deduction amount may be refunded as a mistake in fact but what about the earnings on the refunded amount? Are the earnings also to be refunded, are eligible for rollover or what else can be done.

To ESOP guy, there are both DB and DC contributions which were made while there was no earned income.  The guidance is that you refund the non-deductible amounts.  I don't understand how the funds could possibly stay in the DC plan if they were not justified.  

On a related point, the plan sponsor will NEVER be able to operate the plan long enough to make the contributions deductible, since the business is now closed.

To Madison, you mentioned that earnings should be refunded.  I suspect you are correct, but I have not found the basis for that, beyond the normal common sense opinion that they did not belong to the plan.