The Issue:  When an employer fails to take into consideration all forms of compensation (e.g., commissions, bonuses, etc.) for purposes of employee deferrals to its 401(k) Plan, is that a problem?

The Solution:  Yes.  Unless the specific type of compensation is excluded  in the 401(k) plan document, employee deferral elections apply to all compensation paid by the employer.  Otherwise, an affected employee is described as having  a “missed deferral opportunity,” which generally needs to be corrected by making an employer contribution equal to 50% of the missed deferral opportunity.  In other words, the employer, not the employees, bears the cost of correction.  Depending on the magnitude of the problem, an employer has the option of performing a self-correction or filing a voluntary compliance program (“VCP”) application under the Employee Plans Compliance Resolution System (“EPCRS”) of the Internal Revenue Service.

Analysis:  As you can gather, this type of problem can be an expensive one for employers. Nevertheless, this issue is more common than most employers realize and often arises when employees receive a form of compensation that is paid outside of the normal pay period (e.g., bonus, commissions, etc.) because payroll departments generally must perform tasks outside of their normal routines to accommodate such payments.

While missed deferral opportunities can often go undetected, discovery of this problem could occur at an inopportune time.  For example, we were recently retained by an employer who was in the midst of selling the company. During due diligence, the buyer discovered that the seller had neglected to apply employee deferral elections to bonuses.  A mad scramble ensued to uncover the depth of the problem and the potential impact it had on the transaction.  Ultimately, we were able to assist the seller in crafting a solution that both the seller and buyer were comfortable with, and the deal was completed within the original timeframe.  However, this is a prime example of how missed deferral opportunities could have delayed or even derailed a company-level transaction.

Thus, an employer who sponsors a 401(k) plan should review its payroll procedures and sample deferrals made for various employees to ensure that employee deferral elections are implemented properly. Similarly, an employer that is considering sponsoring a 401(k) plan should consider, and even compile a list of, all potential forms of compensation that its employees receive, and design its 401(k) plan accordingly.  If applying employee deferral elections to a particular form of compensation is especially difficult, the employer should consider whether it makes sense to exclude it when drafting the plan document.  (Note:  Any compensation that is excluded must be nondiscriminatory pursuant to the rules described in IRC § 414(s).)