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The Definition of Compensation: When Operation Does Not Match The Plan

In every qualified plan, such as a Code Section 401(k) plan, there is a specific definition of compensation. It could be based on a different general definition such as compensation reported on Form W-2 or compensation subject to withholding. Some plan documents exclude bonuses, some plans exclude fringe benefits, some exclude neither. There are many options for defining plan compensation. The most important thing is that the plan is administered consistent with the definition of compensation that applies to that plan. And yet so frequently the wrong definition of compensation is used when determining contributions. This can happen because the payroll system was set up, or has evolved, without reference to the terms of the plan. Or perhaps there was an administrative reason for excluding certain items of compensation, but corresponding amendments were never made to the plan document. It is important to understand why the failure occurred for purposes of ensuring it does not happen in the future, and correction for the failure to follow the terms of the plan must be made to ensure the continued qualification of the plan.

Determining the Scope of the Failure

The guiding principle in plan corrections is to put the plan participant in the same position they would have been in had the failure not occurred. So, the first step is to determine what compensation should have been included and analyze what contributions should have been made based on the compensation amount as defined in the plan compared to the contributions that were actually made. The definition of compensation can affect all types of contributions:

  • Deferrals: Deferrals are usually elected as a percentage of compensation. For example, assume a participant elects to defer 5% of compensation and they have $1,000 in salary and $200 in bonus. The plan does not exclude bonuses, but deferrals were only calculated based upon the participant’s salary. In that case, $50 is deferred (5% of $1,000) rather than $60 (5% of $1,200). Under the terms of the plan, the participant should have had $60 in deferrals. Note–if a participant elects a fixed dollar amount, then compensation is not used to determine the deferral contribution.

  • Match: Since matching contributions by definition are tied to deferral contributions, an incorrect deferral contribution amount will generally result in an incorrect match. However, the definition of compensation can also affect matching contributions when there is a limit on matching contributions of a percentage of compensation. For example, using the same facts as in the example above, assume that the plan provides for a match of 100% of deferrals up to 3% of compensation. If compensation is only based on salary, then the maximum match the participant would receive is $30 (3% of $1,000) but under the terms of the plan the participant was entitled to $36 (3% of $1,200).

  • Profit Sharing: Some profit-sharing contributions are allocated pro rata, based on the ratio of the participant’s compensation compared to the total compensation of all participants in the plan. The use of an incorrect definition of compensation can affect both sides of that equation and the affects would need to be analyzed by a re-calculation of the whole profit-sharing allocation.

  • Non-Discrimination Testing: Compensation is also one of the elements used in non-discrimination testing, therefore an analysis should be made whether the correct definition was used for that purpose as well and the effects on plan testing if an incorrect definition was used. The definition of compensation used for testing can be different than that used for plan contributions, but similar system errors can create problems in this context as well.

The Correction

While the examples used above resulted in an inadequate allocation of contributions, it is possible that the use of the wrong definition of compensation could result in an excess allocation (for example, if bonus compensation is excluded under the terms of the plan but included in operation). The correction methods will be different depending upon whether there is an inadequate allocation or an excess allocation. Correction may be made under the general principals under EPCRS [See: What is EPCRS?] IRS safe harbors or a negotiated correction (either through a VCP application or closing agreement with the IRS in the event the issue is raised in an examination):

  • Inadequate allocation: Where there is an inadequate allocation of contributions, a corrective contribution must generally be made by the employer to the affected participants’ accounts. The IRS safe harbor correction in this circumstance would generally require a contribution equal to:

    • 50% of the amount of underpaid deferrals

    • 100% of the amount of underpaid matching contributions

    • 100% of the amount of underpaid profit-sharing contributions

  • Excess allocation: Where there is an excess allocation of contributions, the IRS safe harbor correction in this circumstance would generally require:

    • Distribution of all excess deferral contributions

    • Forfeiture of all excess matching contributions

    • Forfeiture of all excess profit-sharing contributions

All corrections must include lost earnings, if any. Where a correction involves participants who have terminated and taken distributions, additional steps must be taken.

Notes for Best Practices

  • Because this type of failure is a frequent problem for plans, and it can go on for many years before discovery, it is a good idea to include an annual audit of your payroll system and the plan’s definition of compensation in the plan’s administrative procedures to determine that they are consistent.

  • If it is discovered that the incorrect definition of compensation has been used, corrective steps to prevent continued failures, such as updating the payroll system or amending the plan document, should be carried out as soon as possible to limit the liability for the failure.

  • Seek professional help from third-party administrators and legal counsel to ensure the correction is accurate, complete, and appropriate for the specific situation.

  • Review fiduciary liability and corporate errors and omissions policies to determine if the failure is covered and whether reporting to the insurer is required.

  • As with all corrections to qualified plans, before proceeding with any self-correction, an analysis should be done to determine whether the facts and circumstances support eligibility for self-correction, or whether a voluntary compliance program submission is needed.

Please contact our Firm if you would like to discuss any of the foregoing information in greater detail. We would welcome the opportunity to consult with you.

© Boutwell Fay LLP 2019, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of February 28, 2019.

The Definition of Compensation_When Operation Does Not Match the Plan
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