When Bad Things Happen to Good Plans: Preventing errors with eligible compensation plans

For even the most well-intended and conscientious plan sponsor, the complex rules and regulations regarding retirement plans can result in the occasional error in administration or operation. Operational errors are made while carrying out the plan in accordance with the plan document.

Each plan document is unique and defines compensation for 401(k) purposes and in some cases, the plan document defines multiple definitions of compensation for different calculations – like participant elective deferrals, employer-matching contributions, employer profit-sharing contributions and testing.

The IRS has stated that the failure to apply the correct definition of compensation is the most common error identified during examinations.

Significant Operational Errors

The most common error made by plan sponsors regarding compensation is the exclusion of certain categories of compensation – categories that should not be excluded based upon the definition noted in the plan document. The errors occur when determining employee deferrals and employer matches for a pay period. Most business owners think the term “employee compensation” is all about base salary, but it could also include bonus payments, overtime and vacation pay. For example, suppose a plan document defines compensation as W-2 wages. If a plan sponsor gives employees a bonus check and does not withhold deferrals on that check, an operational error has been made.

When plan sponsors fail to withhold on wages that are part of eligible compensation, the plan sponsor should make a corrective contribution equal to 50% of the amount that the employee would have deferred, in addition to 100% of the amount that the plan sponsor would have matched, if applicable. The correction must also include lost earnings, which are calculated from the pay date to the date that the correction has been made. If errors such as these have occurred for prior pay periods, the plan sponsor would still need to correct these errors in the same manner.

Correcting Mistakes

There are several options for correcting overstatements or understatements in participants’ accounts due to inaccuracies related to deferrals and allocations.

1. The Self-Correction Program (SCP). This option is available to plan sponsors that have established a compliance procedure and have practices in place to enable the correction of insignificant operational errors. With this option, there are no IRS-imposed user fees. It is recommended to create a self-correction memo in the event of a future IRS audit.

2. 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.

3. 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.

Avoiding Errors

The IRS offers several suggestions to help avoid errors associated with following the plan’s definition of eligible compensation:

• Review the plan document annually and designate a centralized person or department to maintain all plan documents and the related amendments. If plan documents are amended, this person or department should adopt the amendments in a timely fashion as well as check the definitions of eligible compensation against the old document and note any differences.
• Have a copy of the plan document readily available to review provisions when operating the plan. Use the plan document itself, not a summary of benefits, to administer. Perform a spot-check review on how to apply key provisions of the plan such as compensation, vesting and eligibility on a regularly scheduled basis, preferably before the end of the plan year.
• Develop an internal communications mechanism to advise plan administrators and outside service providers of changes in a timely and accurate manner.
• Provide training to 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 regarding 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. Take steps to try to avoid these errors and make sure your plan remains in compliance. If failures are detected, fully correct them as soon as possible to avoid costly penalties.

Contact your BMF Advisor if you have questions about eligible compensation as it relates to deferrals, allocations or best practices for staying in compliance.