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.
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:
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.
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:
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.