We are sure that you're aware of Internal Revenue Code Section 409A, which altered the way employers are permitted to structure their deferred compensation plans. All nonqualified deferred compensation arrangements had to be amended to comply in form with and be operating in compliance with the Final Treasury Regulations by December 31, 2008. The consequences of a failure to comply are steep: a 20 percent excise tax and interest levied on the employee.
The Internal Revenue Service, in December 2008, issued Notice 2008-113, which implemented a correction program for operational failures (failures to comply in operation to 409A). However, at that point, the Service was unwilling and unsure as to how to implement a correction for plan document failures (a failure of the plan document’s terms to comply with 409A). Specifically, it was concerned about how to do so without giving a free pass to companies who, by sheer unwillingness to comply, had failed to do anything.
In early 2010, the Service issued Notice 2010-6, granting employers who tried to draft their plan documents to comply with 409A, but ultimately failed to do so, the opportunity to correct these plan document failures. However, this opportunity comes with some strings.
Who Is Eligible?
Only taxpayers who satisfy certain requirements are eligible for relief under the Notice. Additionally, requirements for the particular correction method being used and certain information and reporting requirements must be satisfied.
The taxpayer claiming the relief has the burden of demonstrating eligibility for the relief and that each of the eligibility requirements has been satisfied. A taxpayer’s eligibility for relief is subject to examination by the Service.
Relief is not available for all plans or for service providers and certain service recipients who are under examination before correction is completed in compliance with the Notice. Only inadvertent or unintentional failures can be corrected using the Notice, and relief is not available if the failure is directly or indirectly related to participation in a listed transaction under Treasury Regulations Section 1.6011-4(b)(2).
Finally, if the correction requires the service provider to include an amount deferred in income under IRC Section 409A(a), the relief is conditioned on:
- The service provider including the amount in income on the appropriate tax return, paying all applicable federal taxes (including the 20 percent excise tax, but not the premium interest tax); and
- The service recipient complying with the information statement reporting requirements.
The date of correction of a document failure is the latest of:
- The date on which the correction is adopted;
- The date on which the correction is effective; and
- The date on which the correction is set forth in writing.
What Document Failures Are Eligible for Correction?
The following document failures are eligible for correction using the methods outlined in the Notice:
- Certain ambiguous plan terms: Ambiguous terms include: (i) providing for a payment “as soon as practicable” following a permissible payment event, or other similar timing language; and (ii) a designated payment event without a definition or an ambiguous definition.
- Impermissible definitions of otherwise permissible payment events: These include noncompliant definitions of separation from service, change in control and disability.
- Impermissible payment periods following a permissible payment event: The impermissible payment periods include payment periods of longer than 90 days or payments periods that depend on the service provider completing certain employment-related actions, such as returning a signed non-competition agreement, non-solicitation agreement or release of claims.
- Impermissible payment events and payment schedules: Plans can also be amended to correct certain impermissible payment events and payment schedules. Specific rules apply to the following: (i) plans with both permissible and impermissible payment events; (ii) plans with only impermissible payment events; (iii) certain impermissible alternative payment schedules; (iv) impermissible service provider or service recipient discretion with respect to a payment schedule following a permissible payment event (including subsequent deferral elections); (v) impermissible service recipient discretion to accelerate payment events; and (vi) impermissible reimbursement or in-kind benefit provisions.
- Failure to include six-month delay for specified employees: Documents that fail to include the six-month delay of payment to specified employees can also be corrected by amending the plan before the date of an event that would trigger a payment that would be subject to such delay requirements.
- Impermissible initial deferral elections: Relief is also available for initial elections to defer compensation that do not comply with the Code and Treasury Regulations. However, correction is not available for elections as to the time and form of payment of a deferred amount.
What Is the Correction Method?
The correction method typically includes a plan amendment and, in some cases following a triggering event, requires that a portion of the amounts deferred under the plan be included in income under IRC Section 409A (generally 50 percent of the amount deferred, depending upon the failure being corrected). This amount will be subject to the 20 percent excise tax, but not the premium interest tax. In some cases, the plan amendment will give rise to an operational failure that must be corrected using Notice 2008-113. The triggering event for the income inclusion generally keys off the one-year anniversary of the date of correction of the plan document failure.
Is There a Transition Period?
If a plan fails to satisfy the requirements of IRC Section 409A in a manner that is eligible for correction, and if the plan is corrected on or before December 31, 2010, the plan may be treated as having been corrected on January 1, 2009, and any requirement of income inclusion as a condition of the relief will not apply, provided that:
- Any payment made before December 31, 2010, that would not have been made under the amended provision (or any payment not made before December 31, 2010, that would have been made under the amended provision) is treated as an operational failure; and
- Such failure is corrected under Notice 2008-113 on or before December 31, 2010.
Alvarez & Marsal Taxand Says:
We now have the benefit of perspective having lived with IRC Section 409A for over a year. Employers who have discovered a document problem, who may have misunderstood the ramifications of a particular provision or who want a double check should take advantage of this opportunity to review their nonqualified deferred compensation arrangements one last time. If document and operational failures are corrected before December 31, 2010, the onerous adverse tax effects of an IRC Section 409A failure can be avoided. The Service doesn’t generally give taxpayers the chance for a do-over, so this one shouldn’t be ignored.
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