A frequent challenge in plan administration is the use of an accurate definition of compensation for plan purposes. So what is “plan compensation”? You may already know that the term refers to the elements of employee compensation that are included for purposes of calculating retirement plan contributions. But what is your plan compensation? Is it compensation reported on Form W-2? Are there types of compensation that are excluded, such as bonus payments, or is everything on the Form W-2 included? Does it include employees’ pre-tax contributions to their medical insurance and/or other benefits? It’s easy to see how complicated this can get. If you asked people from your HR department and your payroll department, would they know (and agree) what elements of compensation count for your plan purposes?
There are so many reasons a failure happens—the plan administrator did not convey the definition of plan compensation to the payroll department in the first place; the plan sponsor decides to make a change to plan compensation and informs the payroll department but does not make the change in the plan document; or a new source of pay is added but not coded as plan compensation. The resulting qualification failures are really the failure of oversight, communication, and attention to plan provisions.
In order to correct plan qualification failures and maintain a plan’s tax-qualified status, all corrections must follow the process prescribed by the IRS. A basic tenet of the IRS correction program, the Employee Plans Compliance Resolution System (“EPCRS”), is to put the plan in the same position it would have been in had the failure not occurred. The revenue procedure which lays out the requirements of EPCRS (most recently Rev. Proc. 2021-30) describes safe harbor correction methods which are deemed acceptable by the IRS, as well as the various programs through which corrections can be carried out.
What is perhaps a “small” mistake in administering plan compensation can result in significant correction costs because frequently these types of mistakes are not caught early on and the failures can span multiple years and affect many participants. Correction may require corrective contributions of thousands of dollars, in addition to any legal, recordkeeping, or IRS fees. Not only do the correction costs and earnings add up, the passage of time also limits the options for self-correction and can require a filing with the IRS for approval, which has its own costs.
The following examples are based on real situations that we have seen again and again. Note that for simplification, all of these examples discuss bonus compensation, but any type of compensation that is incorrectly treated under the terms of the plan will have the same result. The names have been changed to protect the not-so-innocent.
Example 1: The Compensation that Got Away
The Forgot to Update Company, Inc. develops software that keeps office programs up-to-date with new versions. It has 200 employees and sponsors a 401(k) plan which provides a 100% employer match on deferrals up to 6% of compensation, and discretionary pro-rata formula profit sharing contributions. Forgot to Update made profit sharing contributions in 2015, 2016, 2018, and 2020. The plan defines compensation to be W2 compensation. In 2015, Forgot to Update decides to offer a quarterly “incentive bonus” to its sales associates. The payroll department sets up a new pay source code for the incentive bonuses. The payroll department was not aware that this source of compensation should be included for 401(k) plan purposes and did not code it accordingly. The pay source codes were not reviewed by the benefits department.
In 2021, during the 2020 plan year audit for the Form 5500, a new auditor discovers this failure. Forgot to Update works with its ERISA counsel and recordkeeper and determines that, as result of the mis-coded bonus compensation, the plan had experienced the following failures:
- Failure to make deferrals from the improperly excluded incentive bonus compensation for more than five (5) plan years;
- Failure to make matching contributions on the missed deferrals;
- Failure to make matching contributions up to the full 6% of compensation maximum; and
- Failure to properly allocate profit sharing contributions in four (4) plan years.
Example 2: Let’s Make it Official
The Winging It Corporation has several restaurant locations that specialize in serving a variety of hot wings. They have 150 employees and they sponsor a 401(k) plan which provides for deferrals and a discretionary matching contribution. The plan provides for W2 income as compensation for plan purposes. There is no provision in the plan document providing for a separate election for bonus pay. Accordingly, bonus pay is deferred from like all other W2 income. In 2020, the employer decides to let participants make a separate election for bonuses due to the financial stresses of the pandemic, and 20 participants made elections not to defer from their bonus pay. No amendment was adopted providing for this change in the definition of compensation. Winging It made a 100% matching contribution up to 3% of compensation for the 2020 plan year. In 2021, the sharp-eyed third-party administrator is reviewing contribution data and discovers the failure.
The TPA determines that, as a result of the separate election permitted for bonuses in 2020, the plan had experienced the following failures:
- Failure to make deferrals from the improperly excluded bonus compensation for the 20 employees who elected not to defer from bonuses;
- Failure to make matching contributions on the missed deferrals; and
- Failure to make matching contributions up to the full 3% of compensation maximum
Example 3: We Didn’t Mean It!
Sleeping at the Wheel, LLC is a car detailing company, has 50 employees, and established its 401(k) plan in 2014 on a pre-approved plan document. The plan provides for deferrals and a fixed matching contribution of 20% of deferrals, with no maximum. The 2014 plan document provided that bonuses would be excluded from compensation. The plan was administered accordingly. Then, in 2016, the plan was restated and during the document process, the document vendor failed to mark the box that excluded bonuses from compensation. The employer did not carefully review the restated plan document and adopted it, unintentionally adopting the change to the definition of compensation as of January 1, 2016. The employer continued to administer the plan excluding bonuses from the definition of compensation.
During the plan restatement process in 2021, the benefits attorney discovers the discrepancy in the 2016 plan document and determines that, as a result of the difference between the plan provisions and administration, the plan had experienced the following failures:
- Failure to make deferrals from the improperly excluded bonus compensation for more than four (4) plan years; and
- Failure to make matching contributions on the missed deferrals.
Example 4: But That’s Not Cash!
Cash Only Corp is a business that offers check-cashing services. They have 70 employees and established a 401(k) Plan which provides for deferrals and a 50% match up to 10% of compensation. The plan defines compensation as Form W-2 compensation with no exclusions. Each month, one employee is selected as “Employee of the Month.” Each Employee of the Month receives a $50 Starbucks gift card as a reward. In addition, at the holiday party each year, Cash Only has a raffle and gives away a big-screen television to a lucky employee. The payroll department does not include these amounts in taxable compensation of the employees as it is not “cash.” But that’s not how the IRS sees it. . .
Their CPA alerts them to the fact that the gift cards and television are, in fact, reportable as taxable income on the Form W-2. Cash Out then discusses this revelation with the plan’s TPA, who informs them, as a result of the improperly excluded items of compensation, the plan has experienced the following failures:
- Failure to make deferrals from the improperly excluded gift card and television compensation;
- Failure to make matching contributions on the missed deferrals; and
- Failure to make matching contributions up to the full 10% of compensation maximum
How Must These Failures be Corrected?
Under the IRS safe harbor correction methods, the employers in the above examples will need to:
- Immediately correct going forward to prevent further failures. This is very important to “stop the bleeding” as it were. This will entail updating the payroll system and/or adopting an amendment as applicable.
- Make a corrective contribution for any missed deferrals for all affected years
- Make a corrective contribution for any missed matching contributions for all affected years
- Reallocate any profit sharing contributions for all eligible participants based on the correct compensation amounts.
- All of these corrective contributions and forfeitures must be adjusted for earnings.
- In some cases, a submission to the IRS under its voluntary correction program (“VCP”) will be needed, such as where the failures are significant and the self-correction deadline has passed, or where a retroactive amendment is called for.
How Can These Mistakes be Avoided?
As mentioned at the beginning of this discussion, the failures here are really failures in plan oversight, communication, and attention to the plan provisions. In order to avoid failures related to a plan’s definition of compensation, a plan administrator must:
- Be familiar with the plan document’s definition of compensation;
- Ensure that the payroll department has properly coded the different sources of compensation consistent with the plan’s provisions;
- Communicate with the payroll department any new sources of income and how they should be coded for plan purposes;
- Audit the payroll system against the plan provisions on a regular basis, no less than annually;
- Adopt written plan amendments providing for any changes to the definition that are made in operation; and
- Carefully review any restatements or amendments to avoid unintentional changes to the plan.
Using an inaccurate definition of compensation can be a small mistake that ends up being a big mistake. Such a failure directly affects contributions and can affect a few participants, all participants, or something in between. And even though the amounts involved may be small from payroll-to-payroll, they can go undetected (and therefore uncorrected) for many years, adding up to significant amounts required for correction.
