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Frequent 401(k) Audit Finding Series - Definition of Compensation Failures

Background

Compensation is used for many different purposes in a 401(k) Plan including the calculation of employee and employer contributions.  Accordingly, it is critical that the Plan Sponsor have a firm grasp on how compensation is defined in their Plan.

Internal Revenue Code §415 (IRC §415) allows for one of four definitions of compensation:

1.       Statutory definition
2.       Simplified compensation
3.       W-2 wages, and
4.       Wages for income tax withholding

Note:  These definitions will be explained in the Plan Document (or see IRC §415).  Most types of compensation, with the exception of tips, are included in all of these definitions, so the differences among them will usually be nominal.

Observations

Language, either in the Base Plan Document or adoption agreement, will outline how the Plan defines compensation.  Certain record keepers select a specific definition while others allow the Plan Sponsor to pick from the four allowable choices.

Once the starting point for calculating compensation has been determined, the Sponsor has the ability to exclude certain elements from the definition of compensation.  Common elements that we see excluded from compensation include, but are not be limited to, bonuses, commissions, reimbursements, cash or non-cash fringe benefits, etc.

With this many moving parts, the calculation of eligible compensation can quickly become convoluted.  To further complicate the process, the Sponsor may elect to have different definitions of compensation for different purposes (such as one definition for calculating employee 401(k) deferrals and another for calculating employer profit sharing contributions).

Failures

During 401(k) audits, definition of compensation failures are among the most prevalent failures we encounter.  Many times, these failures can be traced to isolated payroll transactions.  When a payroll clerk assigns employee time to a new, or seldom used, payroll code (i.e., miscellaneous, jury duty, etc.), the underlying programing in the payroll system may not be accurate and the system does not properly calculate the necessary contributions. 

Other times, the failure can be more far reaching as the Sponsor doesn’t have a handle on the choices that were made to define compensation.  A practical example would be that the adoption agreement excludes bonuses from compensation, but operationally, employees are allowed to request 401(k) deferrals be withheld from their bonus payroll.

Corrective action

The recommended corrective action prescribed by the Department of Labor is to adjust historical contributions to what they would have been had the correct definition of compensation been used. 

If an employee originally received too much, employee contributions are to be refunded with any surplus employer contributions forfeited and used in accordance with Plan language. When shortfalls have occurred, additional contributions will be needed.  There are times when the employer will be responsible for making 401(k) contributions on the employee’s behalf and funding a lost earnings component. 

Please feel free to reach out if you have a specific situation where you are looking for clarification.