In the Summer 2011 edition of Retirement News For Employers, the Internal Revenue Service ("IRS") provides guidance on compensation mistakes which incur in qualified retirement plans. The IRS says the following.
Using an incorrect definition of compensation in your qualified retirement plan can lead to costly operational failures that can affect your plan's qualified status. Impacted areas may include:
• Contributions and benefits
For example, a plan operational failure will occur when an employer makes profit-sharing contributions using base compensation instead of base compensation plus commissions as required by the plan document.
• Nondiscrimination requirements
A qualification failure may occur if the plan excludes overtime (or other) pay from its definition of compensation resulting in nonhighly compensated employees receiving a lower contribution rate than highly compensated employees.
• Employer's deduction for plan contributions
A nondeductible contribution may result if the employer uses a higher amount of compensation than that allowed under the Internal Revenue Code (see Code §404). The employer may owe additional tax including excise taxes on the excess (see Code §4972 and Pub. 560 - Excise taxes).
• Highly compensated or key employees, plan limits and top-heavy minimum benefits
The plan will have a qualification failure unless it uses the statutory definition of compensation for these limits and minimums (see Code §§ 415 and 416).
Tips to avoid compensation-related errors:
1. Review your plan document's definitions of compensation for each plan purpose.
2. Use the statutory definition of compensation when required.
3. Transmit accurate compensation data for each employee to your payroll processor and plan administrator.
4. Consider amending your plan to use one definition of compensation for all plan purposes.
5. Periodically review your plan for errors and fix them as quickly as possible using IRS correction programs.
The IRS also provides a more detailed discussion of correcting compensation errors in qualified defined contribution plans.