Internal Revenue Code section 409A ("409A") casts a tangled web that traps many types of compensation arrangements (which may include bonus, severance, or deferred payment or commission arrangements, supplemental plans, employment agreements and equity arrangements) under complex rules regarding "deferred compensation" arrangements. Despite diligent efforts, failures to comply with 409A may be lurking. Employers (or other service recipients) who want to take advantage of the transition relief under IRS Notice 2010-6 ("Notice") for document failures under 409A should be making those corrections a top priority. Transition relief for document failures corrected in accordance with the procedures described in the Notice is available only through the end of the year. Starting January 1, 2011, it will still be possible to correct 409A document failures under the Notice, but only with more limited relief available to employees (or other service providers) affected by the document failure.
Discovery of 409A Document Failures Not Unusual
Employers were given until January 1, 2009, to bring their nonqualified deferred compensation arrangements into documentary compliance with 409A. Most employers—and certainly larger employers—took that deadline seriously, undertaking a massive 409A compliance effort to inventory, review and revise their nonqualified deferred compensation arrangements before the end of 2008.
Despite those herculean efforts, however, it wasn't long into 2009 before 409A document failures started to come out of the woodwork: the stray agreement that had been forgotten from the company's 409A review; the plan provision that may at one time have looked fine but now seems questionable; the missing provision, such as the six-month delay for specified employees, that should have been included for 409A compliance.
Document failures emerge in the context of merger and acquisition deals, too. To discover during the due diligence process that the other party's nonqualified deferred compensation arrangements have some, even many, 409A documentary compliance issues is not uncommon.
Employers With 409A Document Failures Had Few Options Prior to Notice
Having no method sanctioned by the Internal Revenue Service for correcting 409A document errors, companies looking at possible 409A document failures in their nonqualified deferred compensation plans were left with few attractive options. In general, most employers were reluctant to conclude that an arrangement did not comply with 409A, as that conclusion would have triggered the employer's duty to report amounts deferred under those arrangements as includible in income under Code section 409A(a), which in turn would expose its employees to 409A tax consequences.
Those tax consequences are harsh. If at any time during the taxable year a nonqualified deferred compensation plan fails to comply with 409A, the employee must include in income for the taxable year all amounts deferred under the plan for the taxable year and all preceding taxable years, to the extent those deferred amounts are not subject to a substantial risk of forfeiture (and to the extent not previously included in income). Here, "plan" will mean not only the arrangement in which the document failure occurs, but any other arrangement, program, etc. with which it is aggregated under Treasury Regulation § 1.409A-1(c)(2). (That regulation aggregates deferred compensation arrangements of the same one of eight "types," that is, elective deferrals to account balance plans, nonelective deferrals to account balance plans, nonaccount balance plans, separation pay plans, in-kind benefits and reimbursements, split-dollar life insurance arrangements, modified foreign earned income arrangements, and stock rights plans.) In addition, an additional tax of 20 percent on such includible amounts applies. And if the amounts should have been included in income in an earlier taxable year, the employee also will owe interest on the amount of the underpayment at the underpayment rate plus 1 percent.
The undesirability of such a result motivated many employers to struggle hard to muster good arguments that, certain drafting weaknesses aside, the arrangement in question did comply with 409A.
In cases where the deferred amounts under the arrangement had not yet vested, some employers proceeded to make whatever fixes they believed necessary to bring the document into 409A compliance. Such corrections "worked" under 409A, it was argued, because of the wording of Code section 409A(a)(1)(A). That provision states that if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of 409A, compensation deferred under the plan will be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture (emphasis added) and not previously included in gross income. If amounts had not yet vested, so the theory went, the situation was one of essentially "no harm, no foul" per the language of Code section 409A(a)(1)(A), and correction should be possible. Though this theory has been understandably attractive to employers wishing to avoid the severe tax consequences of 409A documentary noncompliance for their employees, employers who have relied on it should also be aware that, to date, it does not seem to have been embraced by the IRS or Treasury.
Employers also crossed their fingers that, in the event of an audit of their nonqualified deferred compensation plans for 409A compliance, the IRS would choose not to subject an employee to the harsh consequences of 409A where the circumstances were otherwise benign. Would the IRS really take action if the employer had made a good-faith attempt to comply with 409A, the document failure in question was unclear, relatively minor, or a technical glitch (think noncompliant change-in-control definition, for instance), and in any case the failure was not plainly offensive to the central principles of 409A? Employers certainly hoped not. And if the IRS chose not to show sympathy to an employee in its enforcement actions, it was further hoped that the courts would.
Notice Provides Correction Procedures for Certain 409A Document Failures
Issued in January of this year, the Notice came as a welcome development to the employers, legal advisors, and other practitioners who had been calling for the IRS to provide some means by which an employer could correct at least certain 409A document failures and avoid the full consequences of 409A noncompliance.
The Notice was issued more than a year later than IRS Notice 2008-113, which provided the corrections procedures applicable to 409A operational failures in December 2008. Operational failures generally occur when a nonqualified deferred compensation plan or arrangement is not administered in accordance with its terms: for instance, a plan participant makes an election to defer 20 percent of base salary, and the employer erroneously defers 10 percent (an impermissible acceleration) or 30 percent (an impermissible deferral) of the participant's base salary. As Notice 2010-6 makes clear, a plan may have not only a 409A document failure but a 409A operational failure as well. In other words, such failures are not mutually exclusive. And depending upon the nature of the document failure being corrected, the corrections procedures under Notice 2010-6 require the correction of any operational failure that results from that document failure.
In a disappointment to some, the corrections procedures outlined in the Notice stop well short of being a corrections program akin to the Employee Plans Compliance Resolution System (EPCRS), the IRS program under which eligible errors under tax-qualified plans can be corrected. But the Notice does offer a mechanism by which certain, although by no means all, 409A document failures may be corrected so that the tax consequences to the employee are either avoided or reduced.
Determined to avoid the corrections procedure effectively serving as a disincentive to having a fully compliant arrangement (which would effectively reward bad behavior), the IRS provided in the Notice for the possibility of still significant tax consequences for participants as part of the corrections procedures, but which still represent significant relief from the full consequences of 409A noncompliance. Most of the corrections procedures require the employee to include an amount in income under Code section 409A(a) if, within the year following the date of the correction (a "look-back year"), an event occurs that would have required payment under the impermissible pre-correction provision. However, the amount of includible income is limited to a percentage—in most cases, 50 percent—of the amount deferred under the plan to which the pre-correction provision applies (and without regard to the 409A plan aggregation rules). Including such amount in income means that the employee will be subject to the 20 percent additional tax under Code section 409A(a)(1)(B)(i)(II) but not the premium interest tax under Code section 409A(a)(1)(B)(i)(I), and the employer must comply with the applicable reporting requirements of the Notice (for example, Form W-2 reporting).
As part of the corrections procedure, the employee also is generally required to attach a notice to his or her tax return of the correction for the year in which the failure was corrected. If an amount is includible in income in a subsequent year as part of the correction, the employee must attach a notice to his or her tax return for that year as well. The employer similarly must attach a notice to its tax return reporting the correction for the year in which the correction was made, and for any subsequent year for which an amount was includible in income by the employee. Additional requirements, which vary depending upon the nature of the document failure being corrected, may also apply under the corrections procedures. A failure to complete all of the required corrections procedures means that the relief in the Notice will not apply to the correction.
Document Failures Corrected Prior to 2011 Eligible for Special Relief
Perhaps the most welcome aspect of the Notice came in the form of a one-time reprieve from the IRS: special "transition relief" for document errors corrected in accordance with the Notice's procedures on or before December 31, 2010. For document failures corrected in accordance with the Notice by that deadline, the income inclusion that might have been required as part of most of the correction procedures described in the Notice, if in the one-year period following the correction a payment event under the pre-correction provision occurred, will not apply. In other words, the affected employee not only will avoid all of the negative tax consequences that would normally arise from a 409A failure, but will also avoid the reduced tax consequences that otherwise would apply because of the event as part of the correction under the Notice.
Failures corrected in 2010 under the Notice will be deemed to have been corrected as of January 1, 2009, which makes the transition relief helpful as far as the post-correction look-back year is concerned. Assume, for instance, a correction is made on December 1, 2010, and on June 1, 2011, an event that would have required payment under the pre-correction provision occurs. Absent the transition relief, such payment would have triggered the income inclusion required as part of the corrections procedures under the Notice. But because the correction made on December 1, 2010 is deemed to have been made back on January 1, 2009, the June 1, 2011 payment event will be irrelevant for purposes of the Notice. The look-back year ended as of January 1, 2010, so that events occurring after that date are disregarded.
Needless to say, this transition relief offers a very favorable result for the employee, and that should be prompting employers to make it a priority to correct their 409A document failures under the Notice before the end of 2010. On the downside, the transition relief does not appear to excuse employees and employers from having to attach statements to their tax returns as part of the corrections process, even though there may be no income inclusion required under the transition relief correction procedure. Not surprisingly, this particular requirement has been unpopular with employers and employees, due in part to the nuisance factor but more so to the concern that such statements may be an audit red flag. Officials from the IRS unofficially have expressed some willingness to consider arguments that such reporting shouldn't be required during the transition period. With no further word from the IRS by this point, however, a reprieve from the information and reporting requirements for corrections made in 2010 seems unlikely.
The IRS has made it clear that the transition relief is a special one-time offer that will not be available after the end of this year. Given the significant stakes for their employees, it is probably worth the effort for employers to look through their existing compensation arrangements for possible 409A document failures. This effort should include an attempt to flush out any arrangement that may have been missed in the company's pre-2009 409A compliance review. If such review uncovers failures eligible for correction under the Notice, employers have the ability to avert potential disaster for their employees by correcting those failures while transition relief is available.
Notice Flags Certain Provisions as Problematic Under 409A
Even employers who believe all of their arrangements fully comply with 409A would do well to give the Notice a thorough reading before deciding that no corrective action is necessary. Some employers have been unpleasantly surprised to realize that certain plan provisions they believed to be compliant with 409A have, in fact, been highlighted in the Notice as eligible for correction. For instance, the Notice describes as an example of a correctible document failure a provision that provides for payments of deferred compensation within 90 days after the employee's separation from service, but not before the employer receives the employee's release of claims and all applicable rescission periods have expired. This sort of provision has been used commonly in employment agreements and other severance arrangements and believed to have complied with the payment timing rules under 409A. The Notice, however, suggests that such a provision impermissibly gives the employee the ability to determine the timing of payment, in that the employee can decide when to deliver his or her signed release of claims to the company, and does not pass muster under 409A.
Not all news is bad news in the Notice, however. Certain terms that some practitioners worried were not compliant with 409A do not, based upon the language of the Notice, seem to be a problem.
Don't Wait Until the Last Minute to Correct
Waiting until late in 2010 to undertake the corrections process may leave an employer scrambling to meet the December 31 deadline. For instance, the Notice provides that, in order for a correction to be eligible for relief under the Notice, the employer not only must correct the failure in the arrangement in which the failure was identified, but must take "commercially reasonable steps" to identify all other nonqualified deferred compensation plans that have a substantially similar failure and correct those failures as well. That is a process that could take some time. To avoid the risk of a fatal time crunch, employers should be getting their 409A document corrections underway now.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.