A common type of plan failure submitted to IRS’s Voluntary Correction Program (VCP) involves a plan’s definition of compensation. These failures may occur when the plan’s definition of compensation includes or excludes bonuses, overtime or commissions and the plan sponsor fails to follow the plan’s definition.
How it happens
Plan compensation failures typically occur when:
- a plan amendment changes the definition of compensation from the plan’s initial terms.
- a box on the plan’s adoption agreement is marked incorrectly.
- the plan document wasn’t carefully reviewed before it was signed.
This results in the plan being written one way but operated in a different way.
How to correct
Make a VCP submission to the IRS under the Employee Plans Compliance Resolution Program (EPCRS), currently set forth in Rev. Proc. 2019-19 (PDF), to:
- Request the IRS approve a retroactive amendment to the plan document to reflect the plan’s operation. VCP considers this failure an operational failure, not a drafting or a typographical error. To correct the plan’s terms, propose a retroactive amendment to the definition of compensation that reflects the plan’s operation.
- Explain the expectations of affected plan participants. For example, did participants think or expect that their bonuses would be included for salary deferrals or matching contributions?
For corrections occurring on or after April 19, 2019, you may be able to use the Self-Correction Program (SCP) to amend the plan document to conform to the plan’s operation instead of making a VCP submission to the IRS.
How to demonstrate participant expectations
The plan sponsor may submit the following types of documents:
- Current and previous plan documents that reflect the definition of compensation
- Summary Plan Description (SPD) usually is the same as the plan document
- Deferral election forms
- Data sheets or summary of benefits that were distributed to the participants
- New hire benefit documents used in new employee orientations that might show examples of how benefits are calculated
- Notices or emails distributed to participants showing how benefits are calculated
- Minutes from board meeting that may specify how benefits are calculated.
Each VCP application is evaluated on the specific facts and circumstances submitted
Plan sponsors need to demonstrate the expectations of participants when the plan document excluded bonuses, overtime or commissions from compensation but the plan included them in operation, and the plan sponsor now wants to amend the plan document to match plan operations. Participants’ pay statements, plan statements and Form W-2 showing deferrals were being made on bonus, overtime, or commission compensation can be used to substantiate expectations. In these types of submissions, the participants already had their salary deferrals and matching contributions calculated using this additional compensation. If the retroactive amendment is approved, the plan would be amended to include bonuses, overtime or commissions in the definition of compensation.
The opposite type of situation would be a plan document that included bonuses, overtime or commissions in compensation but the plan sponsor excluded those amounts of compensation in operation. In that situation, the plan sponsor would request to correct by retroactively amending the plan to exclude bonuses, overtime or commissions from the plan’s written definition of compensation. The plan sponsor would need to demonstrate that the affected participants had expectations that that the plan’s written definition of compensation excluded bonuses, overtime or commissions. If the plan sponsor is able to show this, then the IRS would probably approve a retroactive amendment. If this retroactive amendment is approved, then this definition of compensation would be subject to additional nondiscrimination testing under Internal Revenue Code Section 414(s).
If the plan sponsor can’t prove that the participants had expectations that the plan definition of compensation excluded bonuses, overtime or commissions, it is unlikely that the IRS would approve a retroactive amendment. In this instance, the plan sponsor would need to make corrective contributions to the affected participants, adjusted for lost earnings.
Effective January 1, 2015, the BCDE Company adopted the BCDE Company 401(k) Savings Plan. The plan’s adoption agreement marked the definition of compensation to include bonuses. However, in operation, bonuses were not included when calculating salary deferrals. The plan didn’t have matching contributions. Effective January 1, 2016, BCDE amended the adoption agreement to exclude bonuses from the definition of compensation. BCDE believes a significant operational failure occurred for the 2015 plan year. The plan sponsor discovered this operational error in 2018 and submitted a VCP application. This operational failure wouldn’t be eligible for self-correction under EPCRS because to be eligible for self-correction, BCDE should’ve corrected this failure by December 31, 2017 (Revenue Procedure 2019-19, Section 9.02(01) (PDF)).
Sean is a programmer and his compensation is $90,000. He is one of BCDE’s 12 non-highly compensated employees participating in the plan. He is 45 years old. He received a bonus of $20,000. He defers 12% of his compensation. Sean is ineligible for a catch-up contribution since he isn’t at least age 50. Sean’s salary deferral on his base salary of $90,000 was $10,800. Per the plan document, his bonus of $20,000 should've been considered as part of the 401(k) deferral calculation. Sean should have been able to defer an additional $2,400 since he had a $20,000 bonus, but this additional deferral didn’t occur.
BCDE Company made a submission to the IRS’s Employee Plans VCP. They first asked to be allowed to make a retroactive amendment to conform the plan language to the plan’s operation. BCDE wasn’t able to demonstrate that employee expectations matched the plan’s operation since both the plan document and the SPD specified that bonuses would be included in the definition of compensation. The Company wasn’t able to provide any other supporting documentation.
The IRS didn’t accept BCDE’s proposed correction as it did not satisfy the requirements Rev. Proc. 2019-19, section 4.05 because it would cause a prohibited cutback in violation of IRC 411(d)(6). Subsequently, BCDE revised their submission by proposing a correction that would provide corrective employer contributions to impacted plan participants, consistent with the safe harbor set forth in Appendix A.05. This would make up for the missed deferrals and lost matching contributions, that should have been made on the bonus portion of all affected participants’ compensation.
Conditions for adopting a retroactive plan amendment under SCP to conform the plan document to the plan’s operation with regard to the Plan’s definition of compensation
- The corrective amendment results in an increase of a participant’s benefit, right or feature.
- The increase in benefit, right or feature is provided to all employees eligible to participate in the plan.
- The increase in benefit, right or feature:
- was permitted under the IRC, including, but not limited to, the requirements of IRC Sections 401(a)(4), 410(b), 411(d)(6) and 403(b)(12);
- satisfied the correction principles in Rev. Proc. 2019-19, section 6.02 and any other applicable rules in the EPCRS revenue procedure.
- See Rev. Proc. 2019-19, section 4.05(2)(a).
SCP is not available to retroactively amend the written plan to conform to the plan’s operation if the operational failure did not provide for an increase in benefits, rights or features to all employees eligible to participate in the plan. However, this correction may be available under VCP or, if under audit, Audit CAP.
XYZ Corporation sponsors a 401(k) profit-sharing plan with making contributions plan with 57 plan participants. The written terms of the plan exclude bonus compensation for plan purposes. While conducting a compliance check for the 2017 and 2018 plan years on July 8, 2019, it was discovered that the plan sponsor permitted bonus compensation to be counted for plan purposes. This resulted in increased elective deferrals and matching contributions for two plan participants. XYZ Corporation wants to adopt a retroactive plan amendment, effective as of 1/1/2017, to include bonus compensation under SCP as permitted by Rev. Proc. 2019-19, section 4.05. Unfortunately, the corrective amendment can’t be adopted under SCP because all of the applicable conditions specified in Rev. Proc. 2019-19 have not been met. As all plan participants did not receive bonus compensation, the increase in benefits was not provided to all employees eligible to participate in the plan. While the retroactive plan amendment can’t be approved under SCP, the plan sponsor could seek approval for such corrective plan amendment by making a submission to the IRS under the VCP program.
How to avoid compensation definition failures
The plan sponsor or administrator should:
- When putting a new adoption agreement or plan document in place, perform a thorough page-by- page, line-by-line comparison of the key provisions of the plan.
- Have a copy of the plan document readily available to review plan provisions when operating the plan. Use the plan document itself, not a summary of benefits, to administer the plan.
- 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.
- If failures are detected, fully correct them as soon as possible to avoid costly corrections.