Complicated question on 401k Compensation and Stock Compensation

Working with a 401k plan that had mistakenly defined 401k compensation as W-2 wages with no exclusions. This of course, resulted in several defects - not enough was withheld from employee earnings because of the improper definition of compensation.  (Payroll team was only withholding from regular wages, OT and bonuses). The plan was amended effective 12/1/25 to exclude several earnings types, including equity income, from compensation.   Additionally, the payroll team would not regularly record W-2 stock transactions as they happened throughout the year.  Many were held until the last payroll and reported in December, even though the transaction occurred in July/August.

As I am going through the process of self-correction, I am left with a couple of questions on how to handle some transactions

1)  If an active employee exercised stock in July of 2025, but it was not reported in payroll until December of 2025 (when the plan was amended to exclude stock comp), would that stock transaction be considered compensation for the 401k plan?  The option was exercised when it would have been considered compensation, but not reported in payroll until later when the transaction would be excluded?

2)  For a terminated employee, similar question.  I believe if payment is made within 2.5 months of termination or by end of year (whichever is later), then the payment is to be considered compensation.  However, do I use the exercise date or the date in which the payment was made in payroll?

Thanks for any help I can get on this one.

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Generally, at least for tax purposes, non-cash compensation is taxable to the employee when actually or constructively received (i.e., upon transfer or vesting of stock, exercise of a nonqualified stock option, etc.). It should have been reported through payroll at that time. If it had been, it sounds like it pretty clearly would have been plan-defined compensation.  

Imagine this was a cash bonus paid in July but not reported through payroll until December (after the plan had been amended to remove bonuses from compensation). I'm pretty sure we'd all agree it should have been included as part of the participant's plan compensation in July. 

I agree with the timing as relayed by @EBECatty.  Though I have relayed my views of the required timing under the tax laws, I have a couple of clients who have been advised by their accountants that it is common practice to take the compensation into income not necessarily on the day that the option is exercised but in the same quarter it is exercised.  Under the tax rules, the withholding, etc. should occur at or very near the exercise date (paid or constructively paid).  The accountants noted that employers have some administration issues such as batching equity comp in payroll cycles, waiting for broker confirmations or fair market valuations, or their equity systems or stock agents' systems lag.  It is kind of an "as soon as administratively practicable" attitude.  To delay income inclusion, it seems there should be some impediment to immediate inclusion (e.g., 31.3121v2 allows some flexibility if the amounts are not reasonably ascertainable).  Perhaps the more reasonable argument may be a stock agents' systems showing that the stock is not delivered to or made available to the participant until later so they actually don't have receipt of the optioned stock.  I know that the IRS has informally stated (where I can't recall) that some minor timing differences may not be an issue if the income is included in the correct year and withholding deposits/payments are timely based on when the wages are treated as paid.

Also, under 1.415c-2e, compensation is to be taken into account when it is actually paid or made available (i,.e., constructively received).  As stated above, option income becomes taxable wages at exercise.  

Legal rule... include at exercise.  Real world...maybe short delay 

Perhaps you can fall back on the Plan administrator has the power to interpret the terms of the plan provisions (assume your plan contains that) as long as it is applied consistently.   I don't like taking that position because using this provision really means the Plan admin would be changing the definitions from W-2 wages paid or constructively received to W-2 wages as reported.

Item 2 to me is answered by item 1 response.

Seems like 50% QNEC + full match + earnings (unless Plan or IRS limits kick in).