No Good Deed Goes Unpunished
The protagonist of our previous blog, Non Safe-Harbor Hardship Approvals: Warning: Employer Discretion Could be Ill-Advised, was Mr. Bleeding Heart, an employer who wants to help employees in a financial bind at all costs, which led him to authorize several hardship distributions that were not permitted by the plan document’s provisions. As the saying goes, Mr. Bleeding Heart had good intentions, but now he is a bind of his own, an operational error that he needs to correct. He feels like No Good Deed Goes Unpunished, but there is hope:
The IRS Correction Program: EPCRS EPCRS (the Employee Plan Compliance Resolution System) is an IRS correction program that sponsors of qualified plans can use when they have failed to follow their plan document or the provisions of the Internal Revenue Code, as applicable. The latest version of EPCRS is Rev. Proc. 2021-30 and a copy can be accessed through the IRS website at https://www.irs.gov/pub/irs-drop/rp-21-30.pdf. Mr. Bleeding Heart is encouraged to find out that EPCRS provides correction options for overpayments to participants, such as the ineligible hardship distributions he has authorized.
When the Damage is Done…
Mr. Bleeding Heart authorized hardship distributions for many reasons that were not allowed by the plan’s safe harbor definition of hardship, including wedding expenses, credit card payments, home repairs, home remodeling, and a few more. Our previous blog discussed the process needed to add non safe harbor definitions of hardship to the plan provisions prospectively, but what happens when the damage has been done?
Correction Through a Retroactive Plan Amendment
When the plan operations would have been compliant with the plan document if the plan provisions had included what was done operationally, Section 4.05 of EPCRS permits the correction of the operational failure with a plan amendment to conform the terms of the plan to the prior operations as a corrective action, as long as the amendment doesn’t create another violation.
A retroactive plan amendment can conform the terms of the plan to the plan’s prior operations only if the following conditions are satisfied:
- Per Rev Proc 2021-30, if the plan amendment would result in an increase of a benefit, right, or feature. It is important to note that SECURE 2.0 and IRS Notice 2023-43 expanded the opportunity to operational failures being corrected by a plan amendment if the benefit to any participant is less favorable than original provision, as long as the amendment does not result in something less favorable for a participant. The retroactive amendment does not have to result in a benefit increase for all eligible participants.
- The provision of the increase/change in the benefit, right, or feature to participants is permitted under the Internal Revenue Code and satisfies the correction principles of EPCRS.
In the case of our plan sponsor, Bleeding Heart, Inc., the plan allowed for hardships that met the safe-harbor definition provided by the Internal Revenue Code, but Mr. Bleeding Heart approved distributions for immediate and heavy financial needs that were not on the list of deemed hardships, such as repairs to a home necessary to make it livable. Since Treas. Reg. §1.401(k)-1(d)(3)(i) states that “the determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan.”, the retroactive amendment allowing Mr. Bleeding Heart to use his discretion to grant permissible hardship distributions, such as home repairs that would render a house livable, would likely be an adequate self-correction. Some Good Deeds Do Go Unpunished after all.
The Difference Between Ineligible and Improper Hardships
The problem is that Mr. Bleeding Heart’s kindness didn’t stop at authorizing permissible non-safe harbor hardships that could have been permitted by the plan provisions. He also authorized hardship distributions for wedding expenses, credit card payments, and other optional home remodeling costs that are not an immediate and heavy financial need. As Rev. Proc. 2021-30 states, self-corrections must satisfy the correction principles of EPCRS. Unfortunately, retroactive amendments are not possible for optional or living expenses that would never qualify as an immediate and heavy financial hardship. If the plan sponsor can’t retroactively make the document right, how can he right the wrongful hardship distributions?
Improper Hardship Distributions are Excess Amounts
As we explained in our blog called Give It Back!!!, No?!?!?, Ok, Keep It!, EPCRS provides a mechanism called the Return of Overpayment Correction Method whereby the employer asks the employee to return the overpayment. Under this method, the employer takes reasonable steps to have the overpayment repaid to the plan adjusted for earnings at the plan’s earnings rate from the date of the distribution to the date of the correction of the overpayment. Plan Sponsors may permit an overpayment recipient to choose the method of repayment that will apply to the correction of the overpayment: lump sum or installments. Installment agreements are not an available option in cases in which the overpayment recipient is a disqualified person (as defined in § 4975(e)(2)) or an owner-employee (as defined in § 401(c)).
Logistically, “to the extent an overpayment results solely from a distribution of an overpayment recipient’s benefit under the plan in the absence of a distributable event but the overpayment was otherwise determined in accordance with the terms of the plan, any amount returned to the plan by the overpayment recipient is to be allocated to his or her account.”
In the case of Bleeding Heart, Inc., the amount of the improper hardship was part of the participants’ vested account, to which they would have been entitled had there been a distributable event. Since there wasn’t a distributable event, the participants in question were not eligible for an in-service distribution. As such, the improper hardship distribution is not eligible to be rolled over to an Individual Retirement Account (IRA). For that reason, EPCRS provides that when an Excess Amount has been distributed, the Plan Sponsor must notify the recipient that the Excess Amount is not eligible for favorable tax treatment accorded to distributions from an eligible retirement plan, and, specifically, is not eligible for rollover. This seems like a moot point since the reason for the hardship distribution request was that the plan participant needed to spend the money, and a rollover of the funds is not likely, not at all. Nevertheless, the Notice is Necessary, so Notify!
Doesn’t Somebody Have to Pay?
Not surprisingly, most participants who have received an improper hardship distribution will say that they have spent the money and don’t have it to return. Asking for the money back is not likely to succeed. EPCRS does have some provisions in which a plan sponsor would make a plan whole when the ineligible distribution affects the funding or the amounts available to allocate to eligible participants. However, other participants are not affected when a participant receives an improper in-service distribution of his or her vested account balance, such as an improper hardship.
To exercise an abundance of caution, some ERISA attorneys have recommended that plan sponsors like Bleeding Heart, Inc. contribute an amount equal to the improper hardship to the forfeiture balance to offset against future employer contributions. We always encourage our clients to follow the advice of their ERISA counsel, even in this case, when I thought depositing the amount of the improper hardship to the forfeiture account, only to offset it against the employer contribution that would have been made anyway was an exercise in futility. It accomplished nothing. There was no down-side to playing it safe, but in this case, EPCRS seems to agree with me.
Nobody Has to Pay!!!!
Section 6.06 of the EPCRS indicates that a contribution from the employer is not required. It states: “…to the extent the amount of an Overpayment adjusted for Earnings at the plan’s earnings rate from the date of distribution to the date of the correction is not repaid to the plan, the Plan Sponsor or another person must contribute the difference to the plan. The preceding sentence does not apply when the failure arose solely because a payment was made from the plan to an Overpayment recipient in the absence of a distributable event (but was otherwise determined in accordance with the terms of the plan (for example, an impermissible in-service distribution)). “
In other words, after the plan sponsor attempts and fails to obtain reimbursement from the participant, nobody needs to give the money back to the plan. Contrary to popular wisdom, Mr. Bleeding Heart’s Good Deed Has Gone Unpunished!
