How to Avoid Operational Errors Associated with Eligible Compensation

When they hear the term “employee compensation,” most business owners think about base salary. But there are also other types of compensation that businesses may use as employee payment, such as bonuses, commissions, tips, overtime, car allowances, and even non-cash wages like gift cards and company stock.

Most employee benefit plans include a specific definition of which types of eligible compensation must be considered when determining salary deferrals and employer matching and discretionary contributions. It’s important to use the proper definition of eligible compensation when making these determinations—otherwise, operational defects in the plan can occur.

A Significant Operational Error

The most common problems arising from a failure to follow the plan’s definition of eligible compensation are overstatements or understatements in participants’ accounts due to inaccuracies related to deferrals and allocations. You must correct this significant operational error, and participants’ accounts must be corrected to comply with the plan document.

The IRS website includes an example of an employer that failed to follow the plan’s definition of eligible compensation and how the employer can correct the error:

An employer sponsoring a 401(k) plan with assets between $500,000 and $10 million amended its plan definition of compensation and deferrals in 2005 to include overtime pay. For the most recent plan year, however, the employer improperly excluded overtime compensation when it determined allocations and deferrals.

Three non-highly compensated employees each earned base compensation of $30,000 plus another $10,000 in overtime pay. Each employee had deferral percentages of 4% of compensation, and the plan provides for a fixed profit-sharing allocation of 5% of compensation. It also provides for a 50% matching contribution for deferrals up to 6% of compensation.

In the most recent plan year, each employee properly received a profit-sharing allocation equal to 5% of the $30,000 base compensation (or $1,500). However, they didn’t receive an allocation equal to 5% of the $10,000 in overtime pay (or $500). Also, each employee properly deferred 4% of the $30,000 base compensation (or $1,200). In error, however, the 4% election didn’t extend to overtime pay of $10,000 (or $400).

In addition, each employee properly received a matching contribution of 2% of the $30,000 base compensation (or $600). In error, however, they didn’t receive the matching contributions they would have been entitled to if deferrals had been made from their overtime pay. If the 4% elective deferrals had been made from their overtime pay, they’d have been entitled to receive an additional matching allocation equal to 2% of the $10,000 in overtime pay (or $200).

To correct these errors, the employer should do the following:

• Make an additional profit-sharing contribution of $500 plus earnings for each employee.
• Make an additional qualified non-elective contribution of $200 (or 50% of the missed deferral of $400) plus earnings for each employee.
• Make an additional employer matching contribution of $200 plus earnings for each employee.

How to Correct Mistakes

The hypothetical business in this example has several options for correcting the errors caused by improperly excluding overtime compensation when determining allocations and deferrals:

• The Self-Correction Program (SCP): With this option, there is no IRS-imposed user fees for self-correction. However, practices and procedures must be in place.
• The Voluntary Correction Program (VCP): The correction procedure is the same as it is for the SCP, but a user fee applies based on plan size. The employer must include Forms 8950 and 8951 with the submission.
• The Audit Closing Agreement Program (CAP): The correction procedure is the same as it is for the SCP, but the employer and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction.

How to Avoid Mistakes

The IRS offers several suggestions to avoid the problems associated with failing to follow the plan’s definition of eligible compensation:

• Review the plan’s operations on an annual basis.

• Designate a centralized person or department to maintain all plan documents. If plan documents are amended, this person or department should check the definitions of eligible compensation against the old document and note any differences.

• Develop an internal communications mechanism to advise plan administrators and outside service providers of changes in a timely and accurate manner.

• Train in-house personnel to determine eligible compensation so that they understand the plan document.

• Be sure you understand what your third-party administrators (TPAs) have agreed to provide with regard to information about compensation and deferral amounts. They may rely on you for this information.

• Simplify your plan’s definition of compensation and use the same definition for multiple purposes.

Remaining in Compliance

Errors associated with not following your plan’s definition of eligible compensation can lead to a wide range of problems for your organization and your employees. Therefore, you should take steps to try to avoid these errors and make sure your plan remains in compliance.

How Plan Errors Occur

Errors related to failure to follow an employee benefit plan’s definition of eligible compensation usually occur in one of two ways:

1. The plan’s sponsor failed to follow the plan’s original definition of eligible compensation. Sometimes this is as simple as failing to carefully read the plan document in order to establish the proper compensation to be used for deferrals and allocations. When this happens, the payroll system may not be set up properly from the outset, in which case the error will compound throughout the system to recordkeepers and TPAs.

2. The original definition of eligible compensation is changed but company payroll personnel aren’t notified. The plan administrator or company executive may have executed a plan amendment, but communication didn’t occur among personnel who actually carry out the company’s payroll function.

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