Corrective action for incorrect plan distributions.

Letter Ruling 9633041 dealt with the correction of a plan distribution error, and the tax treatment of that correction. The position taken by the IRS is rather startling, given its concerns about self-correction.

In 1992, a participant received a full distribution from the two employer plans in which he participated, Plan Y (a money purchase plan) and Plan X (a profit-sharing plan). The total distributions, approximately $165,000, were rolled over into five individual retirement accounts (IRAs).

In 1994, the plan administrator discovered that the participant had actually received $14,000 too much from Y and had not received $4,600 of interest that had accrued to him in his final plan year in X.

The employer contacted the participant and asked for the $14,000 back. The participant agreed to return the $14,000, but asked the Service about the tax consequences of taking the amount out of his IRA. He also asked if the correction distribution would affect the original lump-sum distribution treatment, and if the remaining $4,600 in X could be rolled over into an IRA.

The Good News

The IRS ruled that X's failure to distribute the $4,600 amount remaining did not interfere with the participant's right to roll over the original amount to an IRA. The Service cited Rev. Ruls. 83-57 and 69-190 as precedent for this treatment.

The Bad News

The IRS also stated that the excess $14,000 from Y was never eligible for a rollover and was an "excess contribution" to the IRA. The Service stated that the $14,000 should have been included in the participant's income in 1992, and that the employee should have been paying a 6% excise tax under Sec. 4973(a) for each year since then for the excess contribution.

The IRS softened the blow by ruling that the earnings on the excess $14,000 would not be taxable to the individual until actually distributed. Furthermore, the Service did not suggest that the earnings had to be distributed immediately. Noting that earnings on excess amounts are not included in the definition of excess amounts, the IRS ruled the excess $14,000 would not be subject to the early withdrawal penalty exercise tax under Sec. 72(t)(1) when distributed from the IRA. The earnings on that amount, however, would be subject to income and excise taxes when distributed from the IRA.

On the status of the IRAs, the Service concluded that subsequent events, such as excess contributions, may affect an IRA's tax treatment, but not its underlying validity. Thus, neither the IRA's acceptance of the $14,000 amount, nor the corrective distribution of that amount, would affect the status of the IRA.

From Peter I. Elinsky, CPA, LL.M., and Karen M. Field, J.D., Washington, D.C.