Employer Plan Overpayments: Collateral Damage from the Tax Cuts and Jobs Act
By Jeremy Rodriguez, JD
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The U.S. Tax Code is a 74,000-page document with interrelating laws and regulations. Therefore, any time Congress enacts a piece of legislation as massive as the Tax Cuts and Jobs Act (TCJA), there are going to be unintended consequences, or as I like to call it, collateral damage. After passage, it's up to the IRS to sift through the damage and clarify any unresolved issues.
IRS has already issued guidance on a few of these topics, such as Roth recharacterizations, income tax withholding (See Notice 1036 and 2018-14), and the deemed repatriation transition tax. The agency's plan is to release much of the guidance necessary to implement the law within the next 12 to 18 months - a much faster timetable than we saw when the tax code was reformed in 1986. This timetable, however, doesn't consider collateral damage.
One piece of collateral damage affects the repayment and subsequent tax reporting of employer plan overpayments. Until clarified by the IRS, only repayments greater than $3,000 can continue to be deducted in full for the year the repayment occurred. Anything less than $3,000 was a casualty of the elimination of miscellaneous itemized deductions subject to the 2% floor.
Overpayments are a common plan error. In fact, this mistake occurs with enough regularity that the IRS has issued rules on self-correction (i.e., no IRS reporting). When discovered, the plan has a fiduciary duty under ERISA to either seek repayment or adjust future payments to make up for the overpayment. While there are some exceptions to this duty, it is entirely within the plan's discretion to apply them.
Example: Let's say you retire in 2017 and your employer's retirement plan reports your balance as $50,000. Not long after exiting the workforce, you elect a lump sum distribution of the full account and decide not to roll the money over. That amount is paid, reported, and taxed, on 2017's tax filings. However, sometime in 2019, you receive notice from the employer plan that it miscalculated the matching contribution for the 2017 plan year. Because of this mistake, you were overpaid $1,000. So, what happens?
You could ignore the notice and force the plan to take legal action. However, the law is not in your favor, and you run the risk of being liable for the plan's attorney's fees and court costs. On the other hand, you could simply elect to repay the balance and avoid litigation. But what happens when you report your taxes in 2019? Do any 2017 filings have to be amended?
The IRS answered these questions in a 2002 Revenue Ruling. There, the IRS explained that amended filings are not necessary. Instead, the taxpayer will take a deduction for the overpayment in the year it was made (in this example, that would be 2019). The Service held that repayments of $3,000 or less are deductible as employee business expenses. These expenses are considered "miscellaneous itemized deductions" and were subject to the 2% floor. Anything above $3,000 was deductible under another section of the Tax Code that wasn't subject to the 2% floor.
As stated above, TCJA eliminated the deduction for miscellaneous itemized deductions subject to the 2% floor. For this purpose, that means an overpayment of $3,000 or less is no longer deductible! You also don't get to adjust your tax filings for any previous years; not exactly a fair proposition, because you now end up paying income tax on the $1,000 as income in 2017 and as a distribution from the IRA in 2019.
Thankfully, this shouldn't be a common problem for individuals with defined benefit plans. Most participants elect an annuity payment and the normal method of correcting an overpayment under this election is to adjust future payments to recoup the loss. In these circumstances, the tax reporting is correct, and a corresponding deduction isn't necessary. However, any overpayments that were distributed as lump sum distributions would be impacted. Further, any overpayment from a defined contribution plan (such as a 401(k) plan) will be affected.
In the end, this overpayment issue is just one piece of collateral damage from the TCJA's passage. While the IRS and Congress are aware that issues like this exist, resolution could be slow to come. Therefore, it is more important than ever for advisors to remain up-to-date on IRS rulings and pronouncements.