During 2006, we (as TPA) sent a distribution request for a former participant of the plan to the custodian/investment company of the plan with instruction on the payout, requesting 20% federal tax be withheld. The investment company withheld 20% ftw and mailed the check to the plan sponsor instructing them to send to the IRS. Instead, the plan sponsor gave it to the former participant who in turn cashed it. We were not aware of this until the plan sponsor received notification from the IRS regarding the Form 945 that was filed showing the ftw amount for the participant. Any quidance on how this should be handled at this point? Thanks in advance.

You need to correct the 945; I think the form is a 941C. If you already have communication I think I'd send the corrected one directly to the office that is raising the question, with an explanation that it was simply prepared in error.

If you did a 1099 showing withholding then that needs to be corrected too. No sympathy here if that causes the participant any headaches.

Be prepared as client may be forced to pay the withholding.

Plan administrator is responsible for withholding and depositing the withholding unless assigned to the payor. Since the 20% was sent to the client rather than directly to the Feds it seems to me that no such agreement was in place. Which places the responsibilty back on the shoulders of the Plan Administrator/Client. The fact that the client sent it to the participant rather than to the Feds doesn't relieve them of the responsibilility.

First, they need to go to the participant and see if the withholding will be sent back. If not then client can correct 945 using 941-c (section 2 I believe) to show it wasn't collected and request penalty (penalty is the missing withholding) to be waived. 1099-R should be corrected to show 0 withholding. When participant files taxes then it all washes.

If the IRS isn't feeling particularly lenient and the penalty is not waived then client will have to fund the penalty and then seek a refund once participant pays his taxes for the year. If participant doesn't pay then no refund....

Either way the 945 and 1099-R have to be corrected to show the withholding wasn't taken. It's basically about who funds the penalty and when.