Voluntary Corrections to Section 409A Nonqualified Deferred Compensation Plans

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.

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 inadvertent and unintentional document failures and correct all such failures in a manner consistent with Notice 2010-6. 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.

Notice 2010-6 provides:

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 or the use of “termination of employment” or “acquisition” as payment events will not result in a violation as long as the payment is made in compliance with the Section 409A payment requirements.
2. Relief by permitting employers to correct certain document failures without current income inclusion to the employee or the 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.  
3. If the corrected plan provision does affect the operation of the plan within one year of the date of correction, then relief is available by limiting the amount currently includible in the employee’s income and the additional taxes under Section 409A.
4. If the plan is a new type of deferred compensation plan sponsored by the employer, then corrections can be made by 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 (explaining the failure) to its timely-filed (including extensions) original federal income tax return for its taxable year in which the correction is made, as well as in the taxable year in which the employee includes any amount in income. This statement is also required to be provided to the impacted employees. 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. 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. 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;
2. Correction of certain operational failures involving non-insider (a director, officer or 10% owner of the employer) in the immediately following taxable year in which the failure occurs;
3. Correction of certain failures involving limited amounts; or
4. Correction of certain other operational failures that are not otherwise covered by the Notice that are correct by the last day of the employee’s second taxable year following the year in which the failure occurred.

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.