“You keep using that word. I do not think it means what you think it means.” So goes the internet meme based on Inigo Montoya’s complaint to Vizzini about his use of the word "inconceivable" in The Princess Bride movie. In the pension business, there is a term that does not mean what many people think it means. That term is “mistake of fact.”
The term “mistake of fact” appears in the Employee Retirement Income Security Act (ERISA) in a section regarding the exclusive benefit rule. In short, this rule says once money is deposited into a qualified retirement plan, it may not be withdrawn except for the exclusive benefit of plan participants and their beneficiaries. The employer cannot just take part of the money back if it feels like it. Rather, plan money may be used only to pay benefits or legitimate plan expenses.
ERISA goes on to give a handful of exceptions to this rule. One of the exceptions says if a contribution is made because of a mistake of fact, the contribution may be returned to the employer within one year after it was deposited.
Whoo boy. Based on that little crack in the doorway, people try to justify returning money to the employer under all kinds of pretenses. They’ll describe their situation and ask, “Couldn’t this be considered a mistake in fact?” Probably not, for two reasons. Number one, it’s mistake OF fact, not mistake IN fact. And number two, the reasons they are giving for wanting contributions to be returned often do not meet the definition of mistake of fact.
In all fairness, this definition of “mistake of fact” is pretty hard to find. It’s not in ERISA. It’s not in the Internal Revenue Code. It’s not in any regulations or broadly applicable IRS or Department of Labor guidance. About the best explanation we’ve got is in IRS Private Letter Ruling 9144041. Here’s what that letter has to say:
Mistake of fact is fairly limited. In general, a misplaced decimal point, an incorrectly written check, or an error in doing a calculation are examples of situations that could be construed as constituting a mistake of fact. What an employer presumed or assumed is not a mistake of fact.
Well, that pops a lot of balloons. It should be pointed out that a Private Letter Ruling applies only to the taxpayer who requested it. A PLR may not be relied on as precedent by other taxpayers or by IRS personnel. Fair enough, but if the PLR is all there is to work with, you kind of have to rely on it or at least give it strong consideration, like we used to do with the old IRS Gray Book.
There Needs to Be a Fact You Got Wrong
Another way to look at it is, for there to be a mistake of fact, there has to be a fact that is wrong. (And that, in fact, is a fact…Jack.) That being the case, here are some situations and an evaluation of whether or not they meet the definition of mistake of fact:
- An employee elects to defer 15% of pay into a 401(k) plan, but 17% is deferred because of a payroll processing error. The IRS said at a conference 20 years ago that it would strongly argue that the mistake of fact argument does not apply to these contributions.
- An incorrect contribution is made because the employee’s compensation was computed wrong. I would argue that this is the kind of thing the mistake of fact rule is intended to cover.
- A contribution was made to an employee who was not actually eligible for the plan. This sounds more like a plain old mistake rather than a mistake of fact.
- In one IRS Private Letter Ruling, a Limited Liability Partnership had all manner of problems when accounting systems were changed, resulting in an overstatement of the LLP’s income and therefore an excess profit sharing contribution for the partners. The IRS ruled the excess contributions were the result of a mistake of fact and could be returned to the employer.
- Another Private Letter Ruling dealt with a terminated defined benefit plan and a refund of part of the annuity premium because a piece of census data was wrong. The refund was ruled as being the result of a mistake of fact. We actually had a similar situation in our practice. In our case, a retiree had died shortly after the premium was paid. We argued that, because of the mistake of fact rule, the premium refunded to the employer was not a reversion subject to excise taxes. Instead, we coded it as a negative contribution.
- Rather than waiting until after the plan year to deposit contributions, a company deposits profit sharing contributions month by month during the plan year as income is earned. Sometimes, contributions are deposited for someone who ultimately isn’t eligible for a contribution that year. The IRS has opined that estimated contributions like this are not mistakes of fact and therefore cannot be returned to the employer.
- An IRS Notice indicates a contribution may not be returned as a mistake of fact merely because such payment is in excess of the deductible limits. That said, there is a rule about returning nondeductible contributions that were conditioned on their deductibility, but that is not the same as a mistake of fact.
Since there is no broadly applicable official guidance on what a mistake of fact is, an employer who disagrees with conventional thinking about what constitutes a mistake of fact is free to apply for an IRS Private Letter Ruling.
Other Ways to Fix Your Mistakes
When a mistake has occurred, there’s a good chance that it doesn’t qualify as a mistake of fact which would allow you to simply return the erroneous contributions to the employer. Fortunately, there are a couple of other possible remedies.
First, see if the erroneous contribution can be reclassified to a different year. Contributions deposited early enough in a year may be applied either to the prior year or to the current year. If a contribution deposited early in 2021 intended for the 2020 plan year is somehow erroneous or violates a 2020 limit, see if the contribution can be reassigned to 2021. This same flexibility would not be available for a contribution deposited late in 2020. It would be difficult, if not impossible, to reclassify such a contribution for 2021. This is why we normally recommend that an employer wait until shortly after a plan year ends to deposit contributions for that year. You want the flexibility to reassign contributions to the subsequent year if something goes wrong.
If that doesn’t work, the employer will wish to look into the Employee Plans Compliance Resolution System (EPCRS), which has something of a roadmap for fixing errors of various types. Some errors may be self-corrected, while those that are too significant or happened too long ago will require an IRS filing and payment of a sanction.