The amount an employer contributes to a defined contribution plan is based on the compensation paid to employees. Compensation is defined in the plan. If an incorrect amount of compensation is used to determine contributions, the contributions will be incorrect. This will cause an operational failure (failing to follow the terms of the plan in its operation).
The plan document may have multiple definitions of compensation, including definitions for purposes of calculating salary deferrals, matching contributions, and discretionary contributions. The plan is not required to use the same definition of compensation for all contribution types. For example, a plan may allocate discretionary contributions based on an employee’s base salary only, while salary deferral contributions may be based on all forms of compensation including bonuses, commissions and other pay.
In addition, using an incorrect definition of compensation can lead to operational errors in:
- Nondiscrimination requirements,
- Employer’s deduction for plan contributions, and
- Highly compensated or key employees, plan limits and top-heavy minimum benefits.
Errors can occur when:
- the third party administrator or payroll processor does not know the plan’s definition of compensation;
- the plan’s definition of compensation is amended, but the third party administrator or payroll processor is not notified;
- payroll systems are not updated to reflect the revised definition; or
- payroll systems are not updated when the types of compensation paid change.
Contribution errors caused by incorrect compensation figures can be corrected using IRS retirement plan correction programs — known as the Employee Plans Compliance Resolution System (EPCRS) and outlined in Revenue Procedure 2008-50.
The error can be self-corrected, without IRS approval, if the mistake is insignificant or, if significant, if the plan sponsor corrects the mistake within two years. A plan sponsor can use self-correction only if the plan has practices and procedures in place designed to promote overall tax law compliance.
In addition, sponsors may use the Voluntary Correction Program.The summer edition of the IRS’ newsletter is here.
« Pension Funding Remains Credit Concern for U.S. Corporate Issuers