Do You Know Your Plan’s Definition of Compensation?

In every qualified retirement plan, there is a specific definition of compensation. So, what is plan compensation and why is it important? Plan compensation refers to the elements of employee compensation that are included for purposes of calculating retirement plan contributions. 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, and some exclude neither. There are many options for defining plan compensation; however, the most important thing is that the plan is administered consistent with the definition of compensation per the plan document. If it is not, a failure could occur. There are many causes for failures: perhaps the payroll system was set up, or has evolved, without reference to the terms of the plan; maybe the plan sponsor made a change to plan compensation and informed the payroll department but did not amend the plan document; or perhaps a new source of pay was added but was not coded as plan compensation.  Whatever the reason, it is imperative 1) to understand why the failure occurred so it does not happen again in the future, and 2) to correct the failure to ensure that the terms of the plan are being followed and that the plan continues to be qualified.

To correct plan qualification failures and maintain a plan’s tax-qualified status, all corrections must follow the process established by the IRS correction program, the Employee Plans Compliance Resolution System (EPCRS). The guiding principle prescribed by the EPCRS is to put the plan participant in the same position they would have been in had the failure not occurred. Revenue Procedure 2021-30 describes several safe harbor correction methods that are deemed acceptable by the IRS, as well as the other programs through which corrections can be made.

Under the IRS safe harbor correction methods, plan sponsors need to:

• Immediately correct the failure to prevent further failures (and the effects of any existing failure). This may 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.

Note that all of these corrective contributions and forfeitures must be adjusted for earnings. In addition, if the failures are significant and the self-correction deadline has passed, or if a retroactive amendment is needed, a submission to the IRS under its voluntary correction program (VCP) will be needed.

A majority of the time, qualification failures are due to a lack of oversight, communication, and attention to plan provisions. To avoid failures, plan sponsors should:

• 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 (at least 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 may seem like a small mistake, but it can quickly become a big problem. It directly affects contributions and can affect anywhere from a few participants to all participants in a plan. Additionally, even though the amounts involved may be minor from payroll-to-payroll, if they go undetected for long periods of time, they could end up being very significant and require equally significant corrections. Please contact us if you have questions about the information outlined above, our seasoned and experienced employee benefit plan professionals are here to help. You can also learn more about our Employee Benefit Plan Audit  services by visiting our website.

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