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failing nondiscrimination testing - consequences


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Curious as to both strict interpretations and "real life" if different. The following is (really, really) a hypothetical question.

Suppose you have a 125 plan, and despite a couple of mid-year tests that passed, it still ends up failing the Key Employee 25% benefit test. Let's say only one Key, and $10,000 deferred, and to pass, Key could only have deferred $9,000.

You find this out, of course, after the end of the year. So, under the regulations, is the entire $10,000 taxable to the Key, or only the $1,000 excess?

Now, if the answer is the entire $10,000 - is there a "real life" fix where if caught before end of January, the W-2 would simply show $9,000 as a contribution/deferral, and the other $1,000 would show up as normal W-2 taxable income? Or some other "real life" fix? Doesn't seem quite legit to me...

Thanks for any discussion/answers/insights!

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