Correcting Document Failures For Deferred Compensation Arrangements Under Code Section 409A
The Internal Revenue Service (“IRS”) has implemented a program under which sponsors of nonqualified deferred compensation arrangements (“DCAs”) can correct plan documents that fail to meet the requirements of Section 409A of the Internal Revenue Code. Deficient plan documents that are corrected under the program by December 31, 2010 may enable affected plan participants to avoid adverse tax consequences, provided that any resulting operational failures are corrected.
Background
Section 409A imposes strict requirements on the form and operation of DCAs. Deferred compensation broadly includes any compensation paid pursuant to a “legally binding right” more than 2-1/2 months after the close of the year in which the services are performed, or, if later, the year in which the payment right becomes vested. For more information on the basics of 409A, click here to see our series of E-Alerts starting May 4, 2007.
Generally, to comply with 409A, an election to defer compensation must be made before the applicable period of service (with certain exceptions for performance based pay) or, in some cases, before the rights to the amount become vested. Furthermore, deferred compensation may only be paid in limited circumstances including separation from service, a fixed time or schedule, disability, change in control, unforeseeable emergency or death. If a DCA fails to comply with 409A in form or in operation, amounts deferred are includible in income upon vesting (even if not yet received) and are subject to an additional 20% tax and in some situations, interest, payable by the service provider.
On December 22, 2008, the IRS published Notice 2008-113, which contains correction methods for certain failures to comply with 409A in operation. On January 5, 2010, the IRS published Notice 2010-6 containing correction methods for certain 409A document failures. Most recently, on November 30, 2010, the IRS published Notice 2010-80 which expanded and clarified the relief made available in Notice 2010-6 (collectively, the “Notices”).
Most of the correction methods under the Notices require an amendment to the DCA. While the Notices eliminate the 409A penalties altogether with respect to certain corrections, other corrections require income inclusion of a portion of the deferred payment and the imposition of the 20% additional income tax. As described below, the IRS has provided incentives for taxpayers to act quickly in correcting 409A document failures.
Transitional Relief for Corrections by December 31, 2010
The Notices include a transitional period which permits individuals to avoid the 409A penalties related to a plan document failure if the failure and all similar failures are corrected by December 31, 2010; provided any resulting operational failures are corrected under Notice 2008-113. If any payment is made (or not made) on or before December 31, 2010 under the terms of the original DCA (prior to correction) in a manner that would not have been consistent with the corrected DCA had those corrected provisions been in effect, any such payments must be treated as operational failures. Although correction of the operational failure may require certain income inclusion and payment of the additional 20% penalty tax imposed by 409A on deferred amounts, correction of the document failure in accordance with this transitional relief would not require payment of any additional taxes. For example, if a DCA includes an impermissible definition of disability, the DCA may be amended before December 31, 2010 to correct the definition without the imposition of any additional taxes for the plan document failure. However, if a payment had been made under the terms of the original DCA (prior to correction) that would not have been made under the DCA after correction, the amount paid must be corrected as an operational failure and, depending on when the correction of the operational failure occurs, might be subject to the additional 20% penalty tax under Notice 2008-113.
Additional Transition Periods for Linked Plans, Certain Payment Schedules Determined by the Timing of Payments Received by the Employer and Payments Dependent On Employee Action
An extended transitional period ending on December 31, 2011 is also available for (i) “linked plans” which are DCAs where the amount deferred or the time or form of payment is determined or affected by the terms of another DCA such that one or both of the DCAs fails to satisfy 409A and (ii) DCAs with payment schedules that are determined by the timing of payments received by the employer but which violate 409A because they are not objective or discretionary and/or do not provide an objective method of identifying which of the payments received by the employer dictate the amount to be paid to the employee. Correction for linked plans, however, is only available if the linkage between the plans does not affect the time and form of payment under the plans. Individuals may avoid 409A penalties by correcting each of these plan document failures on or before December 31, 2011. If any payment is made (or not made) under the terms of the original DCA (prior to correction) in a manner that would have been inconsistent with the corrected DCA had those corrected provisions been in effect since January 1, 2009 any such payments must be treated as operational failures and corrected under Notice 2008-113 on or before December 31, 2011.
Notice 2010-80 implemented a third transitional period ending on December 31, 2012 for DCAs in effect as of December 31, 2010 that contain certain failures involving payments dependent on employees completing employment-related action (such as the execution of a non-compete agreement), provided that any payments made after March 31, 2011 that could be paid during a period that begins in one taxable year and ends in the subsequent taxable year are made during the subsequent taxable year and provided further that to the extent any amounts remain deferred under the plan, the plan is amended to be compliant by December 31, 2012.
Similar to the tax consequences of the December 31, 2010 transitional period, correction of an operational failure during the extended transitional period may require the payment of the additional 20% penalty tax imposed by 409A on deferred amounts even though correction of the document failure would not require payment of any additional taxes.
For more information on how to correct these types of plan document failures, see the list below of the types of failures eligible for correction under the Notices.
Special Rules for New Plans
Under the Notices, an individual can avoid 409A penalties if a plan document failure is corrected by the later of the end of the calendar year in which, or the 15 th day of the third calendar month following, the date the first legally binding right to deferred compensation arose under the DCA or any other plan that is required to be aggregated with that DCA under 409A. This special rule will be most applicable to newly established DCAs.
Eligibility
The corrections outlined under the Notices generally are unavailable to employers or employees who are “under examination” for the year in which the document failure existed. For this purpose, an employer or employee who is an individual (rather than an entity) is considered “under examination” if he or she is under examination with respect to his or her federal income tax return for the taxable year at issue. Any other type of employee or employer is considered under examination if it has received a written notification from an IRS agent stating that a DCA is under consideration.
For corrections made on or before December 31, 2011, employers and employees that are not individuals (i.e. those who are corporate or other entities) are only considered under examination with respect to any specific document failure that has been specifically identified by the IRS as an issue under examination. Accordingly, a general statement from an IRS agent that a DCA is under examination will not prohibit corrections to that DCA before December 31, 2011. In general, correction under the Notices is not available for intentional failures, stock rights (unless such rights were intended to comply with 409A) or, with limited exceptions, linked plans where the linkage affects the time and form of payment.
In order for a correction to be complete under the Notices, the employer must take commercially reasonable steps to also identify all other DCAs that have substantially similar document failures and correct such failures.
Reporting and Disclosure Requirements
For all corrections other than a correction for ambiguous plan terms, the employer must attach a statement to its return setting out (1) certain information about the employee and the plan to which the correction relates; (2) the eligibility for correction under the Notices and (3) the amount involved with respect to the failure. This statement must be attached to the employer’s timely-filed (including extensions) original federal income tax return for the taxable year in which it corrects the failure as well as for any subsequent taxable year for which the employee is required under the Notices to include an amount in income during such subsequent year.
For all corrections other than a correction for ambiguous plan terms or corrections made during the transitional period, the employer must provide a statement to the employee explaining that the employee is entitled to relief under the Notices, identifying the section of the Notices under which the document failure is corrected and providing certain additional information. The statement should also inform the employee that he or she should attach a copy of the statement to the employee’s income tax return for the taxable year in which the failure was corrected and also to the extent applicable, any subsequent taxable year in which an amount is included in income as part of the correction. The employer must provide this statement not later than the date (including extensions) on which the employer is required to provide an information return (Form W-2 or Form 1099) to such employee for the calendar year in which the failure is corrected, and for the subsequent calendar year if the employee is required to include an amount in income during such subsequent year. If no information return is required for such employee, then the statement must be presented no later than January 31 following the calendar year in which the failure is corrected, and for the subsequent calendar year if the employee is required to include an amount in income during such subsequent year.
The employee must attach to his or her income tax return for the applicable year a copy of the statement provided by the employer with respect to each failure corrected under the Notices other than failures corrected during the transitional period.
Any taxpayer who has obtained relief under the Notices (other than for a correction of ambiguous plan terms) must make reasonable efforts to provide notice to the examining agent upon examination of such taxpayer’s federal tax return that the taxpayer was relying upon the relief provided under the Notices for years covered by the examination.
Types of Failures Eligible for Correction under the Notices
The Notices provide correction methods for a variety of document failures that might appear in a DCA. These corrections relate to eight general categories:
(i) ambiguous plan terms
(ii) impermissible definitions of otherwise permissible payment events
(iii) impermissible payment periods following a permissible payment event
(iv) certain impermissible payment events and payment schedules
(v) failure to include six-month delay for specified employees
(vi) impermissible deferral elections
(vii) impermissible provisions linking DCAs
(viii) payment schedules determined by the timing of payments received by the employer
Because of the transitional relief periods provided under the Notices (the first of which ends on December 31, 2010), employers should promptly determine and correct any DCA document failures under 409A. Accordingly, employers should review their DCAs now to confirm that they have been amended correctly to address 409A. To the extent a DCA has not been amended for 409A or if you are unsure whether your DCA complies with 409A, please contact a member of the Troutman Sanders Employee Benefits and Executive Compensation Practice Group. We would be happy to assist you with any of your DCA questions.
Correction of Ambiguous Plan Terms
Failure: The DCA designates a 409A permissible payment event but requires payment “as soon as possible” following the payment event, or language similar to “as soon as possible” following the payment event.
Correction: Requiring payment to be made as soon as possible following a permissible payment event does not automatically constitute a document failure under 409A as long the provision is interpreted in operational compliance with 409A such that payments are made by the later of the end of the employee’s tax year in which the permissible payment event occurs or two and a half months following the permissible payment event. If payments under this provision are made later than as permitted under 409A, an operational failure has occurred requiring correction under Notice 2008-113. However, if the DCA is interpreted in such a way that payments made under the DCA or another DCA with similar language regularly violate the timing requirements of 409A, that DCA and any other DCA maintained by the employer containing language similar to the provision at issue will be considered as not providing for a permissible payment event. Therefore, to the extent any such ambiguous language is retained, the DCA must be operated in accordance with the timing requirements for payments under 409A.
Failure: The DCA designates a payment event, but does not define the payment event or has an ambiguous definition of the payment event that could be interpreted both to be a 409A permissible payment event and to be an impermissible payment event under 409A (i.e., providing for a payment at “termination of employment” or after an “acquisition” of the employer without further clarification).
Correction: Such an ambiguous payment event does not automatically constitute a document failure under 409A. However, if the payment event is interpreted inconsistently with 409A, any payment resulting from the inconsistent interpretation may be treated as an operational failure and can be corrected under Notice 2008-113 as long as the DCA is amended before the end of the employee’s taxable year during which the operational failure is corrected. The amendment would need to either (i) add language requiring the terms of the DCA to be interpreted as necessary to comply with the requirements of 409A or (ii) set forth explicit definitions of the payment events that comply with 409A. However, any such amendment can only clarify the ambiguous provision and cannot add or eliminate a payment event or expand or narrow the definition of a payment event (except to the minimum extent necessary to satisfy 409A).
Correction of Impermissible Definitions of Otherwise Permissible Payment Events
Failure: The DCA provides for a payment upon an event involving a change in the relationship between the employee and the employer, but such event does not qualify as a “separation from service” as defined under 409A.
Correction: The DCA must be amended to include a definition of separation from service that is a permissible payment event under 409A. Such an amendment must be made prior to the date either of the following has occurred: (i) the payment event under the terms of the original DCA (i.e. before the corrective amendment) or (ii) a separation from service (as defined in the corrective amendment). The amendment may not eliminate or add a payment event or narrow or expand the definition of a payment event (except to the minimum extent necessary to satisfy 409A).
If, within one year following the date of correction, an event occurs that would have been a separation from service (or similar event) under either the amended DCA or the original DCA, the employee generally must include in income 50% of the amount deferred under the DCA, and any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA provides for a payment upon the sale of some or all of the equity or assets of the employer or a change in effective control of the employer, but such event does not qualify as a “change in control” as defined under 409A.
Correction: The DCA must be amended to include a definition of change in control that is a permissible payment event under 409A. Such an amendment must be made prior to the date the payment event as defined under the original terms of the DCA (i.e. before the corrective amendment) has occurred. The amendment may not cause an event that was not a payment event under the original terms of the DCA to become a payment event under the amended DCA.
If, within one year following the date of correction, a transaction occurs that is not a change in control under 409A but that would have been a change in control type payment event under the original DCA, the employee generally must include in income 25% of the amount deferred under the DCA, and any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA provides for a payment upon an illness or other incapacity, but such event does not qualify as a “disability” as defined under 409A.
Correction: The DCA must be amended either (i) to include a definition of disability that is a permissible payment event under 409A or (ii) to remove the payment event. If such an amendment is made before the payment event under the original DCA (i.e. before the corrective amendment) occurs, the provision would not be considered as failing to satisfy 409A. If such an amendment is made after the payment event under the original DCA occurs, the amount paid would be treated as an operational failure that would need to be corrected under Notice 2008-113.
Correction of Impermissible Payment Periods Following a Permissible Payment Event
Failure: The DCA provides for payments following a permissible payment event, but designates a period immediately following the event during which payment can be made or begun as more than 90 days and less than 366 days following the permissible payment event.
Correction: The DCA must be amended either (i) to remove such period altogether (and therefore, require payment upon the date of the permissible payment event) or (ii) to set forth a period immediately following the permissible payment event that complies with 409A (generally a period not exceeding 90 days after the permissible payment event, with no right of the employee to designate the taxable year of payment). To avoid including the deferred amount in income, the amendment must be made before the permissible payment event occurs. If the amendment is made within a reasonable time after the permissible payment event occurs and the payment is actually made or commences within 90 days after the permissible payment event (and the employee cannot designate the year of payment), the DCA would not be treated as violating 409A, but the employee must include 50% of the deferred amount in income. Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA provides for payment upon a permissible payment event under 409A, but directly or indirectly conditions the time of payment upon the employee completing employment-related actions, such as signing a release or a non-compete agreement.
Correction: The DCA must be amended to remove the ability of the employee to affect the timing of the payment as a result of his or her actions. If the original DCA (i.e. prior to correction) requires any payment that is subject to the employee’s action to be made within a permissible designated period under 409A following the permissible payment event, the amendment must require that such payment be made on the last day of the designated period. If the original DCA does not require the payment to be made within a permissible designated period following the permissible payment event, the amendment must provide for payment either (i) upon a fixed date that is either 60 or 90 days after the permissible payment event or (ii) during a specified period of time not longer than 90 days following the permissible payment event (provided that, if the payment period spans two of the employee’s taxable years, the payment must be made during the subsequent taxable year). The amendment may not otherwise change the time or form of payment.
Correction of Certain Impermissible Payment Events and Payment Schedules
Failure: The DCA includes both permissible and impermissible payment events as choices with respect to a deferred amount.
Correction: The DCA must be amended to remove the impermissible payment event. The amendment may be made before the date the employee irrevocably elects the impermissible payment event or the impermissible payment event otherwise applies to the deferred amount. However, if the amendment is made after the date the employee irrevocably elects the impermissible payment event or the impermissible payment event otherwise applies to the deferred amount, the amendment must be made before the date the impermissible payment event occurs. If, within one year following the date of correction, an impermissible payment event occurs that would have required payment under the original DCA (i.e. prior to correction), the employee generally must include in income 50% of the amount deferred under the DCA. Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA provides only for impermissible payment events and does not include any permissible payment events.
Correction: The DCA must be amended to remove the impermissible payment event and instead provide for payment upon the later of (i) the employee’s separation from service (as defined in 409A) and (ii) the sixth anniversary of the date of correction. Such an amendment must be made prior to the occurrence of any of the impermissible payment events. Additionally, the employee must include in income 50% of the amount deferred, and any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA provides for more than one time or form of payment upon the occurrence of a single permissible payment event in a manner that does not comply with 409A. For example, a DCA provides for a lump sum payment upon involuntary separation from service, but installment payments upon a voluntary separation from service.
Correction: The correction for this type of failure depends on the nature of the permissible payment event. If the permissible payment event relates to separation from service and the DCA provides for multiple forms of payment that depend on whether the separation from service is voluntary or involuntary, the DCA must be amended to provide that the form of payment upon a voluntary separation from service will be the same form of payment that the original DCA (i.e. prior to correction) would require on an involuntary separation from service. Such amendment must be made before the date a separation from service occurs under the terms of the original DCA. If, within one year after the correction, the employee has a voluntary separation from service that would have resulted in a different form of payment under the original DCA, the employee must include in income 50% of the deferred amount.
If the permissible payment event relates to a factor other than whether separation from service is voluntary or involuntary, the DCA must be amended by removing forms of payment (in the order set forth in the Notices) until all that remains are permissible payment events without impermissible multiple times or forms of payment. Such amendment must be made before the date a payment event occurs that could result in the impermissible multiple times or forms of payment. Generally, the payment alternatives that must be removed first are those providing for the earliest final payment date or shortest payment schedule. If, within one year after the correction, a payment event corrected under this provision occurs, the employee must include in income 50% of the deferred amount.
Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA gives the employee or employer discretion to change the time or form of payment following a permissible payment event.
Correction: If the DCA provides a default time or form of payment that is a permissible payment event and that would apply absent the exercise of discretion by the employee or employer and neither the employee nor the employer has exercised such discretion, the DCA would not be treated as failing to meet 409A solely because such discretion is included in the DCA. Likewise, if either the employee or employer has exercised its discretion, but then revokes such discretion so that the default time or form of payment applies, the DCA would not be treated as failing to meet 409A solely because such discretion is included in the DCA, but only if the discretion is revoked more than one year before the payment event occurs. If the employee or employer has exercised and not timely revoked its discretion, then the DCA and all other DCAs maintained by the employer that contain similar provisions must be corrected (even if discretion in the other plans has not yet been exercised).
To the extent a correction is required, the DCA must be amended. If the DCA has a default time or form of payment that would apply absent exercise of the employee’s or employer’s discretion, the amendment would need to remove the discretion and apply the default time or form of payment. If the DCA does not have a default time or form of payment, the amendment would need to remove the discretion and provide for the permissible payment event set forth in the original DCA (prior to correction) that would result in the latest final payment date. Such amendment must be made before the date a payment event occurs that gives the employee or employer discretion. If, within one year after the correction, a payment event to which the correction applies occurs, the employee must include in income 50% of the deferred amounts. Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Failure: The DCA gives the employer discretion to accelerate a payment even if a permissible payment event has not occurred.
Correction: The DCA must be amended either (i) to remove the employer’s discretion or (ii) to otherwise make the acceleration permissible under 409A. Such amendment must be made before the earlier of (i) the date the employer irrevocably exercises its discretion to accelerate the payment, or (ii) the date payment has been made as a result of the employer’s exercise of discretion.
Failure: The DCA provides for taxable reimbursements or in-kind benefits that do not meet the requirements of 409A. For example, the DCA provides that the employer will reimburse the employee for country club dues in the aggregate amount of $30,000 to be used over the next three taxable years.
Correction: The DCA must be amended to provide for reimbursements and in-kind benefits that satisfy the requirements of 409A. However, such amendment must cause the amount eligible for reimbursement or in-kind benefits to be allocated pro rata to the number of years during which the employee may be eligible to receive such amounts. For example, if the DCA provides that the employer will reimburse the employee for country club dues in the aggregate amount of $30,000 to be used over the next three taxable years, the correction would require that the employer reimburse the employee for country club dues in an amount up to $10,000 during each of the next three taxable years. Such amendment must be made before the date an event occurs that would result in the employee being eligible to receive a taxable reimbursement or in-kind benefit.
If, within one year after the correction, an event occurs that would have made the employee eligible for payment of reimbursements or in-kind benefits under the original DCA (prior to correction) and results in the corrected DCA being applied to avoid or reduce the availability or payment of such amounts, the employee must include in income 50% of the deferred amount. Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Correction of Failure to Include Six-Month Delay for Specified Employees
Failure: The DCA does not provide for the required six-month delay of payments to specified employees of a public company following a separation from service.
Correction: The DCA must be amended to include the six-month delay and to delay any payments that would be subject to the six-month delay until the later of (i) 18 months following the date of the amendment or (ii) six months following the date of the payment event. Such amendment must be made before the separation from service. If, within one year after the correction, a specified employee has a separation from service, 50% of the amount deferred under the DCA (and delayed under the amendment) must be included in the employee’s income. Any amount included in income will be subject to the additional 20% penalty tax under 409A.
Correction of Impermissible Deferral Election
Failure: The DCA permits initial elections to defer compensation that are not timely under 409A. For example, the DCA permits employees to elect to defer compensation for a taxable year after the last day of the prior taxable year.
Correction: No correction is necessary if the improper provision was not applied such that any initial deferral election was timely. However, if, in accordance with such improper provision, the initial deferral election is not timely made, the DCA must be amended to remove the ability to make the impermissible initial deferral election. Such amendment must be made no later than the end of the employee’s second taxable year immediately following the year in which occurs the 409A deadline for making a timely initial deferral election. Additionally, any amounts that the employee did not receive as a result of the untimely deferral election must be corrected as operational failures under Notice 2008-113.
Correction of Impermissible Provisions Linking DCAs
Failure: The amount deferred under the DCA is determined by, or the time or form of payment is affected by, the amount deferred under, or the payment provisions of, another DCA in a manner prohibited by 409A.
Correction: The DCAs must be amended so that the time and form of payment under both plans are identical. All permissible payment events provided in either of the DCAs must be retained in both of the DCAs. The Notices provide special rules for defining a permissible payment event when alternative definitions are available under the two plans or for determining the time or form of payment when each plan contains the same permissible payment event, but a different time or form of payment. Such correction must be made on or before December 31, 2011. If any amounts have been paid under any of the DCAs (prior to correction) in a manner that would not have been consistent with the corrected DCAs had those corrected provisions been in effect since January 1, 2009, or if any amounts were not paid in a manner that would not have been consistent with the amended DCAs, any such payments must be treated as operational failures and corrected under Notice 2008-113 on or before December 31, 2011.
Correction of Payment Schedules Determined by the Timing of Payments Received by the Employer
Failure: The DCA provides for payment schedules that are determined by the timing of payments received by the employer but which violate 409A because they are not objective or nondiscretionary and/or do not provide an objective method of identifying which of the payments received by the employer dictate the amount paid to the employee.
Correction: The DCA must be amended so that all payment schedules determined by the timing of payments received by the employer are objective or nondiscretionary and provide an objective method of identifying which of the payments received by the employer determine the amount to be paid to the employee. Such amendments must be made on or before December 31, 2011. If any amounts have been paid under any of the DCAs (i.e. prior to correction) in a manner that would not have been consistent with the corrected DCAs had those corrected provisions been in effect since January 1, 2009, or if any amounts were not paid in a manner that would not have been consistent with the amended DCAs, any such payments must be treated as operational failures and corrected under Notice 2008-113 on or before December 31, 2011.
If you have any questions about the new guidance, please contact any member of the Troutman Sanders’ Employee Benefits & Executive Compensation Practice Group.