The Internal Revenue Service (“IRS”) has announced a limited correction program (the “Program”) for certain operational failures of nonqualified deferred compensation plans under Section 409A of the Internal Revenue Code (“Section 409A”). The Program was announced in IRS Notice 2007-100.
As described below, the Program offers complete relief from the adverse tax consequences under Section 409A for certain categories of unintentional operational errors and limits the adverse tax consequences with respect to certain others. Failures to comply with the documentation requirements of Section 409A, which take full effect on January 1, 2009, are not eligible for correction under the Program.
The following summarizes some of the key requirements of the Program. These requirements can be quite detailed and care should be taken to review Notice 2007-100 before determining whether a particular error is eligible for correction and what steps must be taken to achieve correction. See prior McGuireWoods news items relating to Section 409A.
A. Overview of the Program
The Program contains two different parts, each applicable to a different general category of operational error:
- The first category includes certain unintentional operational errors that are corrected in the same taxable year in which they occur, regardless of the amount involved.
- The second category includes certain unintentional operational errors that are not corrected in the same taxable year in which they occur, provided the error occurs before January 1, 2010, is corrected by the end of the second year following the year in which the error occurred and the amounts involved do not exceed the 401(k) elective deferral limit for the year of the error (i.e. $15,500 for 2007 and 2008).
The IRS has also requested comments on a permanent corrections program for operational errors that are not corrected within the same taxable year.
To take advantage of the relief, the service recipient (employer) must take commercially reasonable steps to avoid a recurrence of the error. The Program does not apply to errors that are “egregious” or that are part of an abusive tax avoidance scheme. In addition, except for the limited circumstances described below, exercise of a stock option or stock appreciation right that would result in a failure to comply with Section 409A cannot be corrected under the Program. For those errors that are eligible for correction, relief is conditioned on the timely filing of certain information with the IRS and the service provider (employee), as described in greater detail below.
B. Errors Corrected in Same Taxable Year as Occurrence
Part I of the Program gives full relief from the adverse tax consequences of Section 409A (i.e., immediate income inclusion, 20% additional tax and interest penalty) for certain unintentional operational errors that are corrected within the same taxable year in which the errors occur.
The types of errors eligible for correction are the following:
1. Failure to Defer or Incorrect Payment during the Year. Amounts that should have been deferred but that are paid to a service provider by mistake do not result in a Section 409A violation if the service provider repays the amounts to the service recipient on or before the end of the service provider’s taxable year in which the mistaken payment occurred. The service provider may pay the amount out-of-pocket or by reducing his salary or other compensation for the remainder of the year. If the amount exceeds the applicable 401(k) elective deferral limit for the year and the service provider is an insider under Section 16 of the Securities Exchange Act (a “Section 16 Insider”), the service provider must pay interest as well. The service recipient may, but is not required to, credit investment earnings or losses on the repaid amount (e.g., if the plan is an account-based plan and the amount would otherwise have been credited with earnings or losses if no failure had occurred).
No correction is permitted if the service recipient experienced a substantial financial downturn during the year in which the error occurred or otherwise experienced financial or other issues that indicated a significant risk that the service recipient would not be able to pay the amount deferred when the payment became due.
2. Incorrect Payment that Violates the 6-Month Delay Requirement for Payments Made to Terminating “Specified Employees.” Separate requirements apply to failures to observe the six-month payment delay requirement for payments made on account of separation from service to specified employees of publicly traded corporations. Amounts that are paid to a specified employee before six months have elapsed since the specified employee’s separation from service do not result in a Section 409A violation if the specified employee repays the amounts to the service recipient on or before the end of the service provider’s taxable year in which the mistaken payment occurred. In addition, the repaid amounts cannot be re-distributed until the end of an additional delay period. The additional delay period is equal to the number of days between the mistaken payment and the service provider’s repayment and commences on the later of the date the amount otherwise would have been payable under the plan or the date of the repayment. Therefore, the correction must further delay payment of the incorrect amount for a period equal to the time that the service provider had use of the mistaken payment. As with the error described above, correction is not permitted if the service recipient experienced a substantial financial downturn or significant risk of nonpayment during the year in which the error occurred.
3. Failure to Pay or Incorrect Deferral during the Year. Amounts that should have been paid to a service provider but are deferred by mistake do not result in a Section 409A violation if the service recipient distributes the amounts to the service provider on or before the end of the service provider’s taxable year in which the mistaken deferral occurs. If the service provider is a Section 16 Insider, the remaining account balance (or other deferred compensation) must be debited to reflect any positive earnings that accrued with respect to the distributed amount. If the service provider is not a Section 16 Insider or if earnings were negative, an adjustment to the remaining account balance (or other deferred compensation) is permitted but not required. The service recipient also may, but is not required to, pay reasonable interest or otherwise compensate the service provider for the time of value of money with respect to the delayed payment.
4. Incorrect Exercise Price for Stock Rights Otherwise Eligible for Exemption from Section 409A. If a service recipient intends to grant a stock option or stock appreciation right that is exempt from Section 409A but for the fact that, due to an unintentional administrative error (such as mistakenly using the wrong date to value the shares), the exercise price is less than 100% of the fair market value of the underlying shares on the date of grant, the stock right will be treated as exempt from Section 409A if, on or before the end of the year in which the stock right was granted and before the stock right is exercised, the exercise price is adjusted to meet or exceed 100% of the fair market value of the underlying shares on the date of grant.
C. Errors Not Corrected in Same Taxable Year as Occurrence
Part II of the Program limits the amount required to be included in income and subjected to the 20% additional tax and waives the interest penalty for certain unintentional operational errors that (i) occur in a service provider’s taxable year beginning before January 1, 2010, (ii) are corrected by the end of the service provider’s second taxable year following the year in which the error occurred, and (iii) involve aggregate amounts not exceeding the 401(k) elective deferral limit for the year in which the error occurred ($15,500 for 2007 and 2008). Generally the amount required to be included in income and subjected to the 20% additional tax includes only the amount involved in the error, without regard to other deferred amounts under the same plan or a plan that would be required to be aggregated with the plan under which the error is made.
Note that, in stark contrast to the category of errors correctable under Part I, Part II of the Program does not give complete relief from the adverse tax consequences under Section 409A, but rather limits the impact of these consequences. Consequently there is a strong incentive to catch and correct errors in the same taxable year as they occur if possible. In addition, the relief for errors under Part II is not available if a federal income tax return of the service provider (including a Form 1040) for the year in which the error occurred is under examination with respect to the plan.
The types of errors eligible for correction under Part II are the following:
1. Failure to Defer or Incorrect Payment of Small Amounts. If an amount should have been deferred but is paid to a service provider by mistake and the failure is not corrected under Part I as described above, then the amount that is included in income and subject to the 20% additional tax is limited to the mistaken payment and does not include any other amounts deferred under the plan or that are aggregated with the plan. For this purpose, a failure to observe the six-month payment delay requirement for specified employees of publicly traded corporations is treated as a failure to defer and is eligible for this relief. The relief does not apply if the service recipient experienced a substantial financial downturn or significant risk of nonpayment during the year in which the error occurred.
2. Failure to Pay or Incorrect Deferral of Small Amounts. If an amount should have been paid to a service provider but is deferred by mistake and the failure is not corrected under Part I as described above, then, provided the service recipient distributes the amount to the service provider by the later of the end of the calendar year in which or 2.5 months after the date on which the failure was discovered, the amount that is included in income and subject to the 20% additional tax is limited to the mistaken deferral. The service recipient must either forfeit or add to the payment the amount of any plan earnings attributable to the mistaken deferral and must disregard or subtract from the payment the amount of any plan losses attributable to the mistaken deferral. In addition, the service provider must include the amount in income and pay the additional 20% tax on a timely filed tax return for the year of payment.
D. Information and Reporting Requirements
A service recipient intending to take advantage of the relief under Part I as described above must attach to its timely-filed federal income tax return for the year in which the error occurred a statement containing, among other things, the names and social security numbers of each affected service provider, the name of the affected plan, and a brief description of the error (including dates and amounts involved) and of the steps taken to correct the error. In addition, other than with respect to the error described in Section B.4 above (incorrect exercise price), the service recipient must provide the same information (excluding the names of other affected service providers) to each affected service provider on or before the date on which it is required to provide an information return (W-2 or 1099) to the service provider for the year of the error.
A service recipient intending to take advantage of the relief under Part II as described above is generally required to provide the same information to the IRS and to each affected service provider as required for errors corrected under Part I, except that the applicable reporting year is the year in which the service recipient discovers the error rather than the year in which the error occurred. In addition, solely with respect to the relief provided under Part II, the service provider must also attach to his or her timely-filed federal income tax return for the year in which the error was discovered the statement provided by the service recipient as described above.
E. What the Program Means for Employers
The limited nature of the Program puts a greater emphasis on the proper administration of deferred compensation plans. In particular, since the Program only limits (and does not waive completely) the adverse tax consequences for “small” errors not corrected in the same year as they occur, and since errors that are not “small” (i.e., that involve amounts that exceed the applicable 401(k) elective deferral limit) can only be corrected in the same year as they occur, deferred compensation plans may need to set up procedures for audits to be done during, rather than after, the plan year. This may be especially important for specified employees subject to the six-month delay for payments at separation. In light of the growing use of third-party administrators in recent years, employers and other service recipients should consider how such operational audits should be implemented and what procedures should be in place for administrators to report errors as they are discovered.