W-2 compensation and NQSOs

[Guest Quacka]

Ok, from the regs. and treatises I have read, if a 401(k) plan sponsor is using the W-2 safe harbor definition of plan compensation, then non-qualified stock option (NQSO) exercise income is included in plan compenation (and would also be included under the 3401(a) wages for withholding safe harbor definition).

The adoption agreement I have has a check-the-box to exclude NQSO grant income, but not exercise income.

So should plan sponsors using the W-2 definition indeed include the NQSO exercise income in plan comp? How do they take elective deferrals from this non-cash income? This does not make intuitive sense.

And...correction methods if they are improperly excluding the income? Thanks!

[Guest Quacka]

Update

(1) We concluded that our plan excludes all income from stock-based compensation (either at grant, vesting, or exercise).

(2) We concluded that our plan compensation falls outside the W-2 safe harbor for this reason, and therefore requires compensation nondiscrimination testing. At a high-level, we concluded that the compensation is nondiscriminatory since 95% of our stock-based compensation participants are HCEs, which would serve to drive down the HCE compensation ratio relative to NHCEs.