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They definitely are not deferrals. No deferral election was signed - this is just a payroll error. As you note, they are loan repayments, and are credited to the plan as such. The W-2, if it shows these loan repayments as deferrals is wrong, and should be corrected.

L needs a new W-2, or the payroll records need to be updated before the W-2 is generated. The participant did not have a valid cash or deferred election on file so there can not have been 401(k) deferrals. L's withholding is going to be off since the loan payments were treated as deferrals and not counted in taxable wages. They may end up owing more taxes when they file. If you wanted to pretend that somehow the loan payments were actually deferrals (I don't suggest this) then the loan would be in default and the participant would have a taxable deemed distribution. I suggest having a chat with the office manager and explaining how 401(k) loans work. Besides getting the coding straightened out, they also need to be aware that the loan payments are scheduled to end at some point in the future and they need to stop withholding from the employee's paycheck.

and that the document allows for the allocation in the manner you propose

So they went from a proposed $40k §4980H assessment to having IRS checks in hand totaling over $130k? That's one of the crazier stories I've ever heard. Never heard of that happening in the 226J context. I guess there isn't anything to do but continue to inform the IRS of the error each time and request guidance on how to handle. Maybe next time they'll get $60k...

And just a reminder, the HCE determination for the year is not based on what they earned that year, it’s based on what they were paid in the previous year. And check the document to see how the top paid group election is defined.

If the plan document allows, you can always favor one HCE over another. Plans that cover only HCEs automatically pass testing. As Truphao points out though you will still make TH minimums if the plan is top-heavy. So in your example, of the owner getting max everyone else getting 0 is fine until your plan becomes top-heavy which could be immediately if its a first year plan with no other money in it, could be never if there is a 401(k) component and you have enough non-key HCEs contributing enough to the plan to keep it below 60%. And while you say this is a PS, you still need to look out for 401(a)(26) if it's a DB plan or DB/DC combo plan.

yes, but watch out for minimum TH requirements (if the Plan is TH).