On December 22, 2008, the Treasury Department and IRS issued helpful guidance regarding nonqualified deferred compensation plans under section 409A of the Internal Revenue Code. Notice 2008-113 provides employers with an updated version of the corrections program for plans that fail to comply operationally with section 409A. We described the earlier corrections program in a prior WorkCite article, located here.
Relief Limited to Operational Failures
The new corrections program, like the earlier one, provides a limited opportunity to correct certain failures that arise in the operation of a plan. The new corrections program does not cover failures by nonqualified deferred compensation plan documents to comply with section 409A in form (i.e., a failure of the plan to meet the written plan document requirements specified in applicable regulations). Such plan document failures may be eligible for relief under certain other limited circumstances, as discussed below.
Failures Eligible for Correction
Only certain types of operational failures may be corrected under the new corrections program. They can be grouped into four categories:
- Failures to defer, early payments, excess deferrals and below-market stock rights corrected in the same taxable year in which the failure occurs.
Generally, if the failure is caught and corrected in the same taxable year in which it occurs, there are no section 409A penalties associated with the failure. The corrections program thereby creates a premium on catching an operational failure as quickly as possible.
- Failures to defer, early payments, excess deferrals and below-market stock rights corrected in the taxable year immediately subsequent to the taxable year in which the failure occurs.
The new corrections program adds relief for certain failures that are corrected in the year subsequent to the year in which the failures occur. Like the first correction method, this correction method generally results in no section 409A penalties. However, it is more onerous than the first method in certain respects (for example, by requiring the participant to pay interest on any repayment that the participant is required to make to the plan sponsor of an amount that was not deferred or that was paid early). In addition, this correction is not available for amounts deferred by “insiders” (as described below).
- Failures to defer, early payments and excess deferrals that do not exceed a threshold amount.
A failure that is not corrected in the same year in which it occurs or in the immediately subsequent year may still be corrected by the end of the second taxable year following the year in which the failure occurred. However, the correction only limits the section 409A penalties to the deferred compensation amount involved in the failure, instead of (like the first two correction methods) eliminating the penalties completely. This correction method is also only applicable if the amount involved in the failure does not exceed a specified dollar amount tied to the limit on elective deferrals under qualified retirement plans. This limit is $16,500 for 2009.
- Failures to defer, early payments and excess deferrals regardless of the amount.
There is a proverbial “last bite at the apple” for certain other types of operational errors. Like the third correction method, this correction method only limits the section 409A penalties to the deferred compensation amount involved in the failure, and does not eliminate the penalties completely. As one would expect, it is also more onerous in certain respects than the third correction method (for example, by requiring the participant to repay to the plan sponsor any amounts that were not deferred or were paid early).
The corrections program offers a special transition rule for non-“insiders” for certain operational failures that occurred on or before December 31, 2007. Under this transition rule, 2009 will be treated as the taxable year immediately subsequent to the year of the failure for purposes of applying the above correction methods.
The program also specifies the methods by which corrections must occur in order to obtain relief from adverse tax consequences.
- Failures to Defer / Early Payments: In general, for failures involving early payments or failures to defer, the correction method requires the service provider to repay to the plan sponsor the amounts that should have been deferred. If the service provider is not an insider, the repayments can generally be made with interest over a period of 24 months. If the failure was a failure to comply with the six-month delay rule for specified employees, or involved an early payment of an amount otherwise payable in the same taxable year, the amount must be held by the plan sponsor before it can be paid back to the service provider for a period equal to the number of days between the date of the early payment and the date the payment was otherwise scheduled to be made. Earnings adjustments are generally permissible, but may not be made in the case of a failure to comply with the six-month delay rule and certain other cases.
- Excess Deferrals: For failures involving excess deferrals, the correction method generally requires the plan sponsor to distribute the amount of the excess deferral. Earnings adjustments are generally required for insiders but are only permissible for non-insiders.
- Below-Market Stock Rights: Failures involving below-market stock rights can generally be corrected by increasing the exercise price of the stock right so that it equals the fair market value of the underlying stock on the date of grant. Stock rights that are exercised before the correction is made are not eligible for this correction method.
All of the correction methods described above require the plan sponsor to provide some form of disclosure to both the IRS and the affected participants regarding the failure. Generally, this disclosure is provided at the time the plan sponsor files its original federal income tax return or information return (Form W-2 or 1099) for the year in which the failure occurs or in which it discovers the failure, whichever is applicable.
In addition, the correction methods are only available to the extent the plan sponsor takes commercially reasonable steps to ensure the same or similar failures do not recur in the future. This requirement may substantially reduce a plan sponsor’s ability to correct the same or similar operational failure more than once.
Finally, the correction methods for failure to defer or early payment are generally only available to the extent the failure does not occur during a taxable year of the plan sponsor in which the plan sponsor experiences a “substantial financial downturn.” The downturn must indicate a “significant risk” that the plan sponsor would not have been able to pay the deferred amount at the time it was otherwise due. In light of the current economic situation, this requirement may pose a substantial hindrance to firms otherwise eligible to use the correction methods.
A Note on “Insiders”
As noted above, relief under the correction program is limited, and in some cases completely unavailable, for failures involving an “insider.” For these purposes, an “insider” is generally any service provider that is a director or officer or is directly or indirectly the beneficial owner of more than 10% of any class of any equity security of the service recipient, regardless of whether any class of stock of the service recipient is publicly traded. These determinations are made based on the rules under Section 16 of the Securities Exchange Act of 1934. While public company plan sponsors should be able to readily identify such persons, other plan sponsors may have some difficulty making such determinations.
Plan Document Errors
Despite the inability to correct plan document errors under the IRS corrections program, recently proposed regulations on determining the tax consequences of violating section 409A provide limited relief for certain plan document errors where none of the deferred compensation amounts under the defective plan have vested. Such a plan may generally be amended to comply with section 409A before the first taxable year in which any of the deferred compensation amounts vest, provided that, under the facts and circumstances, the plan sponsor does not have a “pattern or practice” of allowing impermissible changes in the time or form of payment with respect to such nonvested amounts.
For additional information on correcting 409A operational failures or on 409A deferred compensation compliance generally, please contact any member of the McGuireWoods Executive Compensation, Employee Benefits or Labor & Employment Teams, including