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Coming at this from a payroll perspective -- I think they have constructive receipt issues on ALL the income and the IRS will not like this at all. This was not a mistake, but a changing of their minds. From a payroll/tax perspective this is a nightmare approach especially if they have also already submitted FIT/FUTA/FICA and then any state consequences. I don't see where this could be claimed a mistake in fact. They got the compensation, they have deferral elections in place, etc. This is just bad planning on their parts. If I were their accountant, while it does cost them more in taxes, I would suggest leaving it as is and doing a cash investment of the net pay back to the company. Because might just cost more than they had in taxes to fix all the different parts (of which the 401k deductions are just one). Add in loan repayments and it gets even nastier.

I am not a lawyer and not expert with respect to compensation issues, but wouldn't the money put back in be in the nature of an increased investment and not negative compensation? That is, the amounts previously paid out would continue to be treated as taxable ordinary income, and the amounts put back in would be treated as increasing each owner's tax basis in the company, or is that not how the rules work?

ERISA and the tax code wouldn't like it and I don't think the circumstances fit the IRS concept of mistake of fact, which is a suggestion you will get. For income tax purposes I do not think the payees can walk away from the income -- this goes beyond constructive receipt to actual receipt. If the owners want to plow their pay back into the Company, they can do it, but on an after tax basis. They can give themselves a pay cut prospectively, but beware the rules under section 409A if they think they are deferring the pay to better times. I don't think any competent ERISA fiduciary who knows the facts as you tell them will part with the contribution money.

Some participants statements have something saying to the effect that you need to notify us if something is wrong and if you don't we won't go back further than "X" period of time to make a correction. Yes, I know this doesn't address the proper correction method but it could be something to consider in deciding how far to go back. Four years sounds unreasonable, but . . . .

I think so too, but it's not my opinion that matters.

I think there should be a cutoff: if you filed your taxes for a particular year and you did not notice the error, then tough.

Many times a 401(k) will be a better choice than a SEP. But it doesn't look like this is one of them. I agree with Belgarath. I chose solo-401K plan (from etrade) over SEP-IRA as 401K allows me to take a loan up to 50% of the amount without penalty. I'd prefer SEP if not for the loan provision.