Error with Compensation definition - how to fix?

This would be viewed as failing to withhold deferrals from eligible plan compensation, which is considered an operational error and more specifically a missed deferral opportunity (i.e., plan participants missed an opportunity to defer amounts under the plan).  The first method available to correct this error would be to provide the affected participants (1) a corrective contribution in the form of a qualified non-elective contribution (QNEC) that’s equal to 25%-50% of the missed deferral amount, plus (2) if the affected participant is eligible for matching contributions, 100% of any missed matching contribution determined using 100% of any missed deferral amounts (not the reduced 25-50% amount) plus (3) any investment earnings what would have been earned on the contributions made under (1) and (2), if any.  It is likely the percentage used for the corrective QNEC will be 50% as it appears that the error may have started a while back, but it could be less if it has only been occurring for a short period.  If corrected in this manner, the employer should be able to self-correct even if it has occurred for a long period of time, but that would only be if it meets the rules for self-correcting inadvertent failures.  Otherwise, it would only be able to be self-corrected if the error has only been occurring for less than about two years.

The other method to correct the error would entail adopting a retroactive plan amendment to conform the plan document terms to the plan’s operation using an amended comp definition excluding the items you enumerated from the plan’s new comp definition for the period at issue.  If the employer chooses to correct through retroactive amendment, the correction would need to be to submitted to the IRS under VCP.  To get the IRS to agree to the retroactive amendment under VCP the employer would need to explain the expectations of the affected plan participants with regard to these excluded items (here, that they did not expect these items to be included for salary deferrals and matching contributions, if any).  This would have to be shown by submitting SPDs, election forms, data statements or summaries of benefits, statements, notices, employee communications, new hire enrollment materials, or any other documents that indicated that these comp items would be excluded for plan contribution purposes.  If the employer does not have any documents to submit showing that the participants were informed that these comp items would be excluded, it is unlikely that the IRS would agree to the retroactive amendment and it would likely require contributions be made as described above.  Note that retroactive amendments can be used to self-correct but only in instances where the retroactive amendment would increase the benefits for the affected participants.  That would not be the case here.

There could be another correction the employer could propose if a VCP is submitted... under VCP the employer can propose anything it is just whether the IRS would accept what is proposed (not sure what they would propose but maybe they can come up with something).  Also, note that since 2022 VCPs cannot be submitted on an anonymous basis (though you could ask for a pre-submission conference to discuss a potential VCP submission without disclosing the employer’s name, etc. but those conferences are advisory only and non-binding).

as usual, this is not advice....