On Jan. 5, 2010, the Treasury Department and IRS announced a new document correction program for nonqualified deferred compensation plans subject to Section 409A of the Internal Revenue Code. The program is described in Notice 2010-6, located here.
Plans subject to Section 409A have been required to be in full compliance with its requirements since Jan. 1, 2009. Section 409A requires compliance both as to the form of a covered plan as well as to how the plan is operated. Previously, the Treasury Department and IRS had issued a correction program for certain errors in operating a Section 409A-covered plan, but had not provided similar relief for plan document failures until now.
Section 409A requires all material terms of the plan to be set forth in one or more written documents. Material terms for this purpose include: (1) the amount of deferred compensation provided under the plan (or the formula for determining the amount); (2) the time and manner of payment of the deferred compensation; (3) provisions relating to initial and subsequent deferral elections (if applicable); (4) provisions relating to certain permissible payment accelerations (if applicable); and (5) a provision requiring a six-month payment delay for payment upon separation from service to any “specified employee” of a publicly traded service recipient.
Covered plans not containing these required terms in writing, or that contain written terms that fail to comply with these or any other Section 409A requirements, are deemed to violate Section 409A, resulting in accelerated income inclusion and tax penalties for all affected participants in the plans. No materiality threshold for this purpose exists. As a result, even the smallest plan document failure can still result in adverse tax consequences for all participants with respect to all amounts deferred under the plan. Given the complexity of the Section 409A requirements and the ease with which unintentional plan document errors can occur, the potential adverse tax consequences for plan participants are incredibly harsh.
The new plan document correction program mitigates these consequences in certain respects. The following is a general description of key program aspects. The specific provisions of Notice 2010-6 should be carefully reviewed to determine whether and how the program may apply to a particular situation.
General Correction Principles
The general correction principles of the new program are similar to the principles established for other IRS correction programs, including the operational failure correction program for deferred compensation plans. However, the plan document correction program has some unique features.
The new program applies only to unintentional and inadvertent document errors.
Other than during a limited transition period, relief under the program is generally not available for a plan if the employer’s federal tax return for the year in which the document failure exists is under examination by the IRS, or if the participant’s federal tax return is under examination for the year in which the document failure exists and the examination specifically cites the nonqualified plan as an issue under consideration in the examination.
Relief is not available under the program for document failures involving stock rights. Other than during a limited transition period, relief is also not available for failures due to the amount deferred under a plan being determined by, or the time or form of payment affected by, the amount deferred under or the payment provisions of another plan or qualified plan (i.e., “linked plans”).
Significantly, relief under the document corrections program is not conditioned on whether or not the employer has experienced a financial downturn during the year of the failure. This was (and remains) a condition for certain corrections under the operational correction program. The financial downturn condition has proven to be a thorny obstacle in some cases, due to the recent recession.
Once a document failure is discovered, an employer generally must take commercially reasonable steps to identify all other nonqualified plans that have document errors substantially similar to the error initially discovered, and correct those plans as well.
The employer must also comply with the specific correction procedures outlined for each type of document failure eligible for correction. For example, corrections for certain document failures require that participants include in income a specific percentage (generally 50%, but sometimes a lesser percentage) of the total deferred compensation subject to the failure, and pay the 20% penalty on that includible amount (but not the premium interest tax). The correction is not deemed complete until such amounts are paid and properly reported.
The program creates incentives for employers to discover and correct plan document failures as early as possible. As a general matter, correction of a defective plan provision will require reduced income inclusion, and payment of the 20% penalty on that includible amount, only if payments under the plan (as in place prior to the correction) would have been triggered within one year of the date on which the correction is made.
Example: If a plan includes an impermissible definition of “separation from service” (such as transferring from a parent organization to a wholly owned subsidiary), and the employer corrects the definition, only those participants who actually transfer during the one-year period following the date of the correction will have a reduced (50%) income inclusion event and owe the 20% penalty. Participants who transfer after the one-year period is up are not required to include any amount in income on account of the transfer.
Finally, like the operational corrections program, an employer who takes advantage of the document corrections program must attach a detailed information statement to its federal income tax return that describes the failure and the correction steps taken. The employer is also generally required to provide a notice to each of the participants affected by the correction at the same time the employer sends out its W-2 statements.
Types of Errors Eligible for Correction
The program provides a laundry list of various plan document errors that may be corrected. Correctible plan document errors include the following categories of errors, each of which is discussed in more detail below:
- Impermissible payment events
- Impermissible payment periods following a permissible payment event
- Plans with certain impermissible payment events and payment schedules
- Failure to include six-month delay of payment for “specified employees”
- Impermissible initial and subsequent deferral elections
Impermissible Payment Events
Section 409A requires that plans specify in writing the triggering events for payment, such as a designated time or event, or a participant’s separation from service. Most of these payment-triggering events have specific definitions under the Section 409A regulations and a plan’s failure to properly reflect the definitions could result in adverse tax consequences for participants. For example, a plan that permits an employee to receive payments upon a “separation from service” that is defined to included a transfer of employment from a parent company to a wholly owned subsidiary would not comply with the Section 409A definition of “separation from service.”
The correction program permits plan sponsors to amend erroneous descriptions of the following payment triggers to cause the plan to comply with the requirements of Section 409A:
- Separation from service
- Change in control
Plan sponsors utilizing the program to amend impermissible payment events must replace the impermissible payment event with a Section 409A-compliant definition. In addition, plan sponsors must monitor whether payment would be triggered within one year of the amendment under the pre-correction plan terms. Participants who would have become eligible to receive a payment due to their separation from service or a change in control (as defined by the pre-correction plan terms) within the one-year period following the amendment will be subject to reduced income inclusion and additional taxes (but not the premium interest tax).
Impermissible Payment Periods Following a Permissible Payment Event
Section 409A also restricts the payment periods in which plan sponsors may make payments following the occurrence of a Section 409A-compliant payment event. Notice 2010-6 provides plan sponsors the ability to correct plan provisions that either contain one of the following:
- Payment periods of longer than 90 days following a permissible payment event, or
- Payment periods following permissible payment events that are dependent upon certain employee actions (Example - executing a release of claims or noncompetition agreement).
Generally, plans containing these impermissible payment periods may be amended to comply with Section 409A prior to the payment event with no adverse tax consequences to participants. The correction program also permits plan sponsors to correct payment periods in excess of 90 days after the occurrence of the payment event. However, participants will be subject to reduced income inclusion and additional taxes.
Certain Impermissible Payment Events and Payment Schedules
Aside from the impermissible payment events described above, the correction program extends relief to plans containing other impermissible payment events, or plans that provide for a payment schedule that does not comply with Section 409A. Specifically, the correction program addresses the following types of impermissible payment events or payment schedules:
- Plans containing Section 409A-compliant payment events and noncompliant payment events (Example – payment upon separation from service and payment upon a participant’s child enrolling in college).
- Plans not containing any Section 409A-compliant payment events (Example – a plan that provides for payment upon a participant’s child enrolling in college).
- Plans permitting multiple forms of payment upon the occurrence of a single payment event (Example – a lump sum payment upon voluntary separation from service and installment payments upon involuntary separation from service).
- Plans permitting an employer or participant to change the time or form of payment following the occurrence of a permissible payment event, including impermissible subsequent deferral elections (Example – a feature allowing participants to make a subsequent deferral election 30 days prior to a permissible payment event).
- Provisions allowing plan sponsors discretion to accelerate payment events (Example – plan provides for installment payments unless the employer elects to make a lump sum payment).
- Impermissible reimbursement or in-kind benefit programs (Example – company paid country club membership with an aggregate rather than a per-year dollar cap).
Generally, plans may be amended to remove such impermissible payment events, and where necessary, include specific payment triggers required under the correction program. Plans with problematic payment schedules can generally be amended to comply with Section 409A by removing the ability of a plan sponsor or participant to alter the timing and form of payment.
However, plan participants may still face reduced income inclusion and additional taxes following a corrective amendment, if an impermissible payment event occurs following amendment of a plan. Also, plan sponsors in some circumstances must also ensure that all similar errors are corrected in its other plans.
Six-Month Delay of Payment for Specified Employees
Section 409A requires that plans sponsored by publicly traded companies (including affiliates of such companies) impose a six-month delay for payments made to “specified employees” on account of their separation from service. The correction program provides relief for plans that do not include such a provision. A plan may be corrected prior to a specified employee’s separation from service to add the six-month delay provision. However, the provision must delay payments to the date that is the later of (1) 18 months following the date of correction; or (2) six months following the date of the payment event. Also, a participant who incurs a separation from service within one year of the correction must include in income a reduced amount deferred under the plan to which the pre-correction plan provision applies in the year in which he or she separates.
Impermissible Initial Deferral Elections
Plans that, by their terms, allow participants to make impermissible initial deferral elections may also be corrected. An impermissible deferral election feature that has not been applied by a plan sponsor or participant may be corrected without any penalties assessed to participants. Impermissible deferral elections that have already occurred may also be corrected no later than the end of a participant’s second taxable year following the year in which the election occurred by amending the plan document and following the correction procedures for operational failures set forth in Notice 2008-13. These correction procedures generally involve including amounts previously deferred in a participant’s income.
Additional Errors Eligible for Correction
Notice 2010-6 also permits employers who adopt new types of nonqualified deferred compensation plans to correct errors. Plan sponsors considering utilizing this correction program will need to review any existing nonqualified deferred compensation plans, and may be required to treat any amounts paid under a noncompliant plan term as operation failures and follow the applicable correction procedures in Notice 2008-13.
2010 Transition Relief
Notice 2010-6 also provides special transition relief for plan document errors corrected on or before Dec. 31, 2010. Errors corrected before this deadline are considered to have been corrected on Jan. 1, 2009, and any requirement of an income inclusion as a condition to relief under the notice will not apply, provided that any impermissible payments made before Dec. 31, 2010, are treated as operational failures and corrected according to Notice 2008-13. This special rule does not relieve employers of the obligation to attach information statements to their tax returns or to comply with other applicable notice requirements.
Also, transition relief is available for impermissible provisions linking nonqualified deferred compensation plans corrected on or before Dec. 31, 2011. Linked plans corrected on or before this date will not be treated as failing to comply with Section 409A. The correction procedures provide specific guidance regarding the requirements to de-link payment timing provisions under such plans. Finally, Notice 2010-6 offers transition relief for plans providing for payments on a fixed schedule that is based on the timing of payments received by the plan sponsor (for example, payments made upon receipt of accounts receivable) and for plan sponsors who may already be subject to an IRS examination.
Specific Plan Document Issues
Notice 2010-6 identifies certain specific plan document issues that the Treasury Department and IRS believe would constitute per se plan document failures eligible (in some cases) for correction under the program. Some of these issues have not previously been specifically identified in the Section 409A regulations or any other generally applicable guidance, and constitute new substantive guidance on compliance with the Section 409A requirements. Employers should carefully review their existing Section 409A arrangements to determine whether any of these specific issues are presented.
Notable examples of provisions that the program indicates are per se plan document failures include:
- A “change in control” definition that includes an initial public offering of the service recipient’s stock, or a plan that otherwise provides for payment upon an initial public offering.
- Payments (such as Section 409A-covered severance payments) conditioned upon the execution by the employee of a release of claims or noncompetition agreement, even if the payment is otherwise required to be made within 90 days (or some shorter period) following the employee’s separation or the occurrence of some other payment event.
- Tiered severance plans or other covered arrangements that vary the form of payment depending on what “level” the employee has attained at the time of his or her separation, regardless of whether any employee has in fact transitioned from one level to another.
On the flip side, the notice also clarifies that certain ambiguous provisions will generally not result in a plan document violation, as long as the terms are otherwise applied in accordance with Section 409A. These provisions include requiring payments to be made “as soon as practicable” following a permissible payment time or event (but that do not otherwise specify a payment time or window), or provisions requiring payment upon “termination of employment” or “acquisition” (without specifically referencing the Section 409A definitions of “separation from service” or “change of control”). These provisions can generally be amended at any time to more strictly conform to the requirements of Section 409A, without having to follow the notice and reporting procedures or include any amounts in income.
Although the notice offers some welcome relief in certain areas to plan sponsors facing documentary compliance issues, it is not a panacea. Nearly every type of correction requires a notice to be filed with the IRS, and many of the corrections require amounts to be included in affected participants’ income (and subjected to the 20% penalty) if the defective provisions would have been triggered within one year of when the correction is made.
In general, it may be advantageous to consider whether there are any other viable means of addressing plan document issues before utilizing the program set forth in the notice. For example, the notice apparently leaves open an existing fix for plan documents that provide only non-vested deferred compensation amounts, previously discussed here.
For further information, please contact any of the authors or any member of the McGuireWoods employee benefits practice.