Voluntary Corrections To Section 409A Nonqualified Deferred Compensation Plans

Monday, June 25, 2012 - 14:19

It has been almost eight years since the enactment of Section 409A setting forth the complex rules governing the timing, form and tax treatment of nonqualified deferred compensation payments. The final regulations under Section 409A were effective January 1, 2009, at which time non-grandfathered deferred compensation plans had to be updated to comply with the rules. Operationally, nonqualified deferred compensation plans have had to comply with the published guidance since January 1, 2005.

Since 2009, Internal Revenue Service (IRS) has begun auditing deferred compensation plans and arrangements. IRS has been requesting detailed documentation of the plans. Some of the areas of focus of these IRS audits have included (1) review of all plans of deferred compensation for compliance; (2) review of modifications made to plans and arrangements; (3) identification of specified employees and compliance with the six-month payment rule; (4) employee’s initial and second deferral elections; (5) review of stock right arrangements; and (6) accelerated payments.

Service recipients (for purposes of this article, service recipient will be referred to as employer) that maintain nonqualified deferred compensation arrangements may want to review their documents and procedures for any Section 409A compliance violations. IRS has provided voluntary compliance programs for employers to use to correct document failures (Notice 2010-6, 2010-3 IRB 275) and operational failures (Notice 2008-113, 2008-51 IRB 1305). Corrections made pursuant to these Notices are done without IRS approval. If employers self-correct violations prior to an IRS audit, the sanctions may be significantly reduced.

The following is a brief overview of the compliance programs available to employers to correct plan document and operational failures.

Correction Of Plan Document Failures

IRS issued Notice 2010-6 to provide employers with the opportunity to review their plan documents and voluntarily correct many types of failures to comply with the document requirements under Section 409A.

In general, to take advantage of Notice 2010-6, the service provider (for purposes of this article, service provider will be referred to as employee) and the employer may not be under examination with respect to nonqualified deferred compensation for any taxable year in which the document failure existed. In addition, the employer must take commercially reasonable steps to identify all nonqualified deferred compensation plans that have substantially similar document failures and correct all such failures in a manner consistent with Notice 2010-6. The failures must be inadvertent and unintentional failures to comply with the requirements of Section 409A. In addition, the failures may not be related, directly or indirectly, to participation in any listed transaction, i.e., one of a group of tax-oriented transactions identified as abusive by IRS. In certain circumstances, the employee must include a portion of the deferred amount in income and pay all applicable federal taxes, including the 20 percent tax under Section 409A. Finally, the employer must also comply with the information reporting requirements as provided in Notice 2010-6.

Notice 2010-6 provides the following:

  1. Clarification that certain language commonly used in plan documents will not cause a document failure. The use of “as soon as reasonably practicable” for the timing of a payment after a permissible payment event will not result in a document failure if the payment is made no later than the later of the end of the employee’s taxable year in which the permissible payment event occurs or the 15th day of the third calendar month following the permissible payment event. In addition, if a payment event is not defined or has an ambiguous definition (e.g., “termination of employment” or “acquisition”), that will not result in a violation as long as a payment is made in compliance with the Section 409A payment requirements.
  2. Relief by permitting correction of certain document failures without current income inclusion or additional taxes under Section 409A provided that the corrected plan provision does not affect the operation of the plan within one year following the date of the correction. For example, if a plan that provides for both permissible and impermissible payment events is amended to eliminate the impermissible payment events, then as long as an employee does not become entitled to a payment during the one-year period following the date of correction, the employee is not required to include any portion of his or her deferred compensation in income, and the payment of the additional Section 409A taxes is not required.
  3. Relief by limiting the amount currently includible in income and additional taxes under Section 409A for certain document failures if correction of the failure affects the operation of the plan within one year following the date of correction. Under these circumstances, the employee will be required to include 50 percent of the amount deferred under the plan to which the pre-correction plan provision applied and pay all applicable federal income taxes as well as the 20 percent tax under Section 409A, but not the premium interest tax.
  4. Relief by permitting correction of certain document failures without current income inclusion or additional taxes under Section 409A if the plan is the employer’s first plan of that type and the failure is corrected no later than the later of the end of the calendar year in which, or the 15th day of the third calendar month following, the date the first legally binding right to deferred compensation arose under the plan.

Besides making the appropriate corrections and, if applicable, reporting income to the employee, the employer must attach a statement to its timely-filed (including extensions) original federal income tax return for its taxable year in which the correction is made. In addition, if as a result of the correction the employee is required to include an amount in income in a year subsequent to the year of correction, the employer is required to include the statement in its income tax return for such subsequent year. This statement is also required to be provided to the impacted employees. Notice 2010-6 details the information required to be included in the statement depending on the type of plan correction made. In addition, depending on the correction, each employee impacted by the amendment must attach a copy of the statement received from the employer to his or her income tax return.

Correction Of Operations Failures

Under Notice 2008-118 (as modified by Notice 2010-6 and Notice 2010-80, 2010-51 IRB), employers can obtain relief from the full application of the income inclusion and the additional taxes for employees under Section 409A with respect to certain failures of a nonqualified deferred compensation plan to comply in its operation with Section 409A.

To be eligible for relief under Notice 2008-113, the employer must take commercially reasonable steps to avoid a recurrence of the operational failure. Further, the relief is not available if the employee’s federal income tax return for the year in which the operational failure occurs is under examination with respect to the plan. To qualify for any applicable relief, the employee is required to repay the employer the amount erroneously paid or made available to the employee. Finally, relief is not available with respect to any erroneous payment occurring during any taxable year of the employee in which the employer experiences a substantial financial downturn.

The only corrections permitted under Notice 2008-113 include (1) the failure to defer an amount or the incorrect payment of an amount payable in a subsequent taxable year; (2) the incorrect payment of an amount that is payable in the same taxable year or the incorrect payment to a specified employee; (3) excess deferral of compensation in the same taxable year; and (4) the correction of the exercise price of a stock right otherwise excluded from the definition of nonqualified deferred compensation. The permitted corrections fall within one of the following:

  1. Correction of operational failures in the same taxable year as the failure occurs - If the correction occurs in the same taxable year as the failure, then the employee has to repay the employer the amount that was erroneously paid by the end of such taxable year. If the repayment causes an immediate and heavy financial need on a non-insider (a director, officer or more than 10 percent owner of the employer), the repayment can be made over a period not to exceed 24 months. If the employee is an insider, he or she may also have to pay interest to the employer. The amount erroneously paid to the employee that is repaid to the employer is not included in the employee’s income and is not reported on a Form W-2 or Form 1099.
  2. Correction of certain operational failures involving non-insider in the immediately following taxable year in which the failure occurs - The employee who is not an insider must repay the erroneous payment to the employer by the last day of the calendar year following the calendar year in which the failure occurred. There is an extended period if the repayment would cause immediate and heavy financial need on the employee. The employee has to pay interest on the repayment. The erroneous amount paid has to be reported on a Form W-2 or Form 1099; however, the employee is not subject to the 20 percent tax under Section 409A or the premium interest tax. When the repayment is made in the following tax year, the employee is entitled to an income tax deduction for the repayment.
  3. Correction of certain failures involving limited amounts - This relief is only available if all the requirements are satisfied by the end of the employee’s second taxable year following the year of the failure. For amounts erroneously paid to the employee, they are taxable when paid and subject to the additional 20 percent Section 409A tax but not the premium interest tax. The taxable amount has to be reported on a Form W-2 or Form 1099. If the employee deferred more than permitted under the plan, then only the amount that is not in excess of the limit on elective deferrals under Section 402(g) ($17,000 for 2012) is available for correction under Notice 2008-113. Reimbursement has to be made by the end of the employee’s second taxable year following the year of the failure. The amount has to be properly reported on Form W-2 or Form 1099 with a Code Z in the appropriate box. The employee is subject to the 20 percent Section 409A tax but not the premium interest tax.
  4. Correction of certain other operational failures that are not otherwise covered - Under this relief, correction must still be made on or before the last day of the employee’s second taxable year following the year in which the failure occurred. Any erroneous payment made to the employee has to be repaid to the employer, with interest if an insider. The erroneous payment is taxable in the year paid and is subject to the Section 409A 20 percent penalty tax, but not the premium interest tax. The employee is not entitled to an income tax deduction for the repayment. On the other hand, if there is an excess deferral, i.e., an amount was not paid but should have been, the excess deferral must be paid to the employee. The employee will have to include the excess deferral in income in the taxable year in which the excess deferral should have been paid. In addition, the employee will be subject to the 20 percent Section 409A tax, but not the premium interest tax.

The employer must attach a statement to its timely-filed original federal income tax return for its taxable year in which the failure occurred. The statement needs to include, among other things, (1) names of the impacted employees; (2) description of the failure and how it occurred; (3) description of steps taken to correct the failure; and (4) a statement that the employer is eligible for the correction program. In addition, the employer must provide similar information to the employee no later than the date, including extensions, on which the employer is required to provide to the employee an information return (Form W-2 or Form 1099) for the calendar year in which the error occurred.

Dennis A. Minich, Managing Director of WTAS, has over 35 years of tax experience. Dennis specializes in compensation and employee benefit issues, primarily relating to qualified retirement plans, nonqualified plans, employee health and welfare benefits and executive compensation.

Please email the author at dennis.minich@wtas.com with questions about this article.