One of the most common errors submitted to the IRS Voluntary Correction Program (VCP) involves the Plan’s Definition of Compensation. If the definition used in operation does not match the definition stated in the Plan Document, a failure has occurred.

The Importance of the Definition of Compensation

The Definition of Compensation is critical to a Plan’s design because it directly impacts:

• The calculation of employee deferrals (the money employees choose to contribute to their 401(k)).
• The calculation of employer contributions (such as matching or profit-sharing contributions).

If this definition is incorrect or inconsistent, it can result in errors in how deferrals and contributions are calculated, which can lead to penalties or the need for correction.

Common Causes of Errors in the Definition of Compensation

Errors related to the Definition of Compensation can arise from a variety of reasons:

1. Plan Amendments: If a Plan Amendment changes the definition but the operations of the Plan are not updated accordingly, this can lead to discrepancies.

2. Incorrect Adoption Agreement Selections: An incorrectly marked box or misinterpretation on the Plan’s Adoption Agreement may also lead to the wrong definition being used.

3. Misunderstanding the Plan Document: A lack of understanding of the Plan Document or Adoption Agreement can result in the application of an incorrect definition.

4. Operational Failure: The Plan’s operational practices may not reflect the definition set forth in the Plan Document, which could lead to errors in calculating deferrals or contributions.

In short, any time the Definition of Compensation used in Plan operations does not match what is dictated by the Plan Document, an error has occurred. Because of this failure, types of compensation may have been incorrectly excluded or included which could require corrective contributions or distributions.

Correcting the Error

When an error in the Definition of Compensation occurs, it’s crucial for the Plan Sponsor to address it in a timely manner. There are two main correction methods, depending on the nature of the error:

1. Retroactive Amendment (No Participant Expectation of Change)

• Situation: If the definition used in operation aligns with participant expectations but differs from the written Plan Document, a retroactive amendment may be allowed under EPCRS.

• Correction Process: The Plan Sponsor would:

  1. Amend the Plan to reflect the correct definition of compensation, matching what was used in practice.
  2. Submit a VCP submission to the IRS, proposing the retroactive amendment.
  3. Validation of participant expectations is required, meaning the sponsor must show that participants reasonably expected deferrals and contributions to be handled in the manner they were.

• No Corrective Contributions Needed: Since participants were expecting the operations to reflect the incorrect definition, corrective contributions or distributions are not necessary under this method.

• Note: Retroactive amendments cannot be used if the plan would fail a qualification requirement (e.g., nondiscrimination testing) after the amendment.

2. Corrective Contributions or Distributions (Incorrect Definition Used)

• Situation: If the definition used in operation was not in line with the Plan Document or what participants reasonably expected, corrective contributions or distributions are needed.

• Correction Process: The Plan Sponsor must restore any missed contributions, or over-contributions, and include earnings on those amounts. For example:

  • Bonus payments: If bonuses were erroneously excluded from the compensation definition but were actually included in deferrals, the bonus amounts must be restored to the participants, along with any earnings that would have accrued.

• Goal: To place participants in the position they would have been in had the error not occurred.

VCP Submission

If the error has caused significant discrepancies and cannot be corrected through the Self-Correction Program (SCP), the IRS will require a VCP submission to fix the issue. The submission involves providing the IRS with a detailed proposal of the correction method and any necessary adjustments to the Plan’s operations and participant accounts. VCP submissions are made through Pay.gov using Form 14568. Fees are based on plan size and outlined in the current version of Rev. Proc. 2022-4.

Preventing Errors in the Future

To avoid errors related to the Definition of Compensation in the future, Plan Sponsors should:

• Review the Plan Document regularly and ensure that the operational definition of compensation aligns with the written definition in the Plan.
• Communicate with Service Providers: Ensure that third-party administrators or other service providers are aware of any changes in the Plan Document and are applying the correct compensation definitions.
• Training and Education: Make sure all relevant personnel understand the plan’s provisions, including the Definition of Compensation, to prevent unintentional errors.

For Assistance with Compensation Errors

If you need help, contact Ekon Benefits at (314) 367-6555 or info@ekonbenefits.com.

Straight From the Source

401(k) Plan Fix-It Guide- You didn’t use the plan definition of compensation correctly for all deferrals and allocations: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-you-didnt-use-the-plan-definition-of-compensation-correctly-for-all-deferrals-and-allocations

Rev. Proc. 2021-30 – EPCRS: https://www.irs.gov/pub/irs-drop/rp-21-30.pdf