But, it is clear that the substance of the tax-gross up payments are compensatory. That is, if this person were not an employee, the company would not be making the gross up payment. The gross up payments are taxable for Federal income taxes and would likely be covered as "compensation" under the plan, but I would check the definition anyway to be sure.
This is not clear. Are you saying the employer does not want the employee to defer into the 401(k) from the gross up? If so, why? To reduce a match?
Do you mean to say that the payments were eligible compensation for deferral under 401(k) plan?