Bonus Exclusions in 401(k)

[Guest Chaffee]

I had this post on the Correction Forum, but was given a suggestion to add into the 401(k) Forum (hopefully will generate some responses).

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I know this is fairly common issue, but I wanted some clarification from different previous posts. I apologize in advance for the length, but wanted to drill deeper into this issue. 401(k) Plan Sponsor has not been taking deferrals on Bonuses for a number of years. Plan document INCLUDES Bonuses in definition of Compensation.

FIRST QUESTION

Is this specific situation covered under Rev Proc 2003-44 Appendix B Section.02 - "Exclusion of Eligible Employees"? Specifically, is the "Expansion of Correction Method to Partial Year Exclusion" meant to correct the exclusion of deferrals from periodic bonuses (that were otherwise allowed to participate) or is this section meant only to apply to situations when a participant is excluded from participating at all for a portion of the year.

Many posts here seem to indicate that the proscribed correction in this section (using ADP and ACP % of respective employee group) would be appropriate.

Others indicate that the failure is not following the employee direction (i.e. standing deferral %) and that the correction would require using the actual employee deferral election in effect (under the general principle of putting the Plan in same position it would have been in).

Has anyone had specific interaction with the IRS on which correction is proper?

SECOND QUESTION

If you believe that the ADP and ACP %'s should be used, I have some clarification questions.

It is my understanding that using the ADP% and ACP% is suggested because this would ensure that the plan would still pass the ADP/ACP test and not need to be recalculated (e.g. if correction is for prior years).

However, in the case of bonus corrections, does this mean that ALL eligible employees would receive a corrective contribution (at the ADP%) or only those employees that have been otherwise deferring (on all other non-bonus Compensation).

For example, assume you have 3 NHCEs with the following Deferral %s

NHCE 1 10%

NHCE 2 2%

NHCE 3 0%

Average ADP for Group = 4%

Under the Correction in Appendix A & B, would all 3 NHCE's receive a correction equal to 4% of Bonuses or would the 4% only be given to NHCE 1 & 2? If the latter is used, it would seem that this would change the overall average ADP of the NHCE group (which contradicts the reason for using the ADP %).

To keep the Non-Discrimination Test results the same, it would seem reasonable that you would use a "modified" ADP% for "participating employees" in this situation (10% + 2% / 2 = 6% Average) and give 6% to NHCEs #1 and #2.

FINAL QUESTION

If using the ADP% for a correction under Appendix A Section .05, which ADP% would you use if the Plan is restructured for testing purposes? Would you use the ADP Test Results before or after restructuring? Language at the end of the Section .05 seems to indicate that you would use test results before restructuring (please clarify this reading is correct).

[WDIK]

I have not had any "specific interaction with the IRS" on this topic, but from my perspective it seems clear that you have a failure to withhold an elected amount. It does not make any sense to me to try to correct this based on ADP or ACP percentages. How would it be equitable to participants that affirmatively elected to defer 10% of their salary if they only received 5% based on the ADP?

If you haven't already, you may want to review this thread.

[Guest jhall]

I've been involved in corrections where the original deferral election was used to make the correction and IRS approval was obtained . In one case that was part of a larger fix and tests were rerun. In another case the facts were such that changes to the percentages did not raise testing concerns. As a general matter I think you are probably stuck using the individual deferral election percentages unless the IRS provides some additional adminstrative shortcut for these situations. On the one hand I can see where simply using the existig ADP number would be ok since the participants received all of the bonus in pay and the plan amount is something of a windfall but it is hard to get around the fact that there is a clear percentage where that number just doesn't exist in the case of an excluded participant.

[Guest Chaffee]

WDIK - Thanks for the thread - I had seen that after my initial posting and seems like we're all experiencing the same issue.

I hope that the "forthcoming" revisions to EPCRS noted in that thread arrive soon and address the "windfall" issue. It would seem that some sort of compromise is needed as the current correction is a bit onerous and completely eliminates any responsibility for employees to monitor their elections.

JHall - thanks for adding your input as well. My gut was that you would be stuck using the standing deferral elections, rather than the ADP/ACP amounts, but I had received conflicting answers. Based on some subsequent research, it seems like the ADP/ACP would be for Section 410(a) Exclusion failures, but the issues here are 401(a) Allocation Failures (requiring the actual standing elections).