Year-End Deadline for Section 409A Corrections
Kenneth A. Mason, Thursday, November 18, 2010 | Filed under: Nonqualified Plans, Deferred Compensation, Executive Compensation
Employers and their executives should note a year-end deadline for correcting certain failures to comply with the “documentation” requirements of Section 409A of the Internal Revenue Code. As explained in our March 2010 article, IRS Notice 2010-6 created a program for correcting such failures, but with many of its generous transitional rules expiring on December 31, 2010. Given the IRS’s “evolving” position on certain Section 409A issues, even those employers whose nonqualified plan documents have already been reviewed and amended for compliance with this Code provision would be well-advised to take one more look at their documents before this transition relief expires.
Background of Section 409A
Most employers are now familiar with Section 409A. It applies quite broadly, sweeping in not only traditional nonqualified deferred compensation arrangements (such as supplemental retirement programs, incentive compensation arrangements, and Section 401(k) “excess” plans), but also employment agreements, severance agreements, and certain equity compensation plans. IRS regulations make clear that, in order to comply with Section 409A, an employer must have appropriate written documents, and those documents must then be administered in accordance with their terms.
The penalties for failing to comply with Section 409A are onerous, falling primarily on executives and other employees who are entitled to receive the nonqualified deferred compensation. They include the immediate inclusion in taxable income of all vested amounts, an additional penalty tax equal to 20% of those taxable amounts, and interest assessments commencing from the dates each of those amounts became vested.
Notice 2010-6
After finalizing its Section 409A regulations in the spring of 2007, the IRS announced a correction program for operational violations in late 2008 (Notice 2008-113). In early 2010, the IRS issued Notice 2010-6, the first (and still only) official guidance on correcting documentation failures. The key advantage of correction under Notice 2010-6 is that any correction is then deemed to have been made as of January 1, 2009, when documentary compliance with Section 409A became fully effective. This allows an employer to shield its executives from the onerous tax penalties.
Only certain documentation failures are eligible for the relief provided under 2010-6. Moreover, the Notice includes a one-year “look-back” provision. If a correction made under this Notice has no effect on a plan’s operation for one year thereafter (e.g., because a distribution is to be made on an executive’s separation from service and the executive does not separate during that one-year period), the affected executive will generally escape any adverse tax consequences. If a plan’s operation is affected within one year after the correction is made, the Notice still provides for only a partial income inclusion (plus the 20% penalty tax on that partial amount) and no interest assessment.
Employers should recognize that correction under Notice 2010-6 may also require a simultaneous correction of an operational violation under Notice 2008-113. Corrections of operational violations may have their own tax inclusion requirements.
Moreover, Notice 2010-6 conditions its relief on compliance with certain reporting requirements. An employer who corrects a documentation failure under this Notice must attach a statement to that effect to its income tax return and then provide a copy of that statement to all affected employees. Those employees must then attach that statement to their tax returns in order to enjoy the relief provided under this Notice.
Payments Conditioned on Signing a Release or Noncompete Agreement
One of the surprises contained in Notice 2010-6 was a more restrictive interpretation of Section 409A’s application to a plan or agreement that conditions payment of deferred compensation on an employee signing either a release of legal claims or an agreement not to compete. Recognizing that such a condition could effectively give an employee discretion to determine the taxable year in which a payment will be made (simply by timing his or her signing of the release or noncompete agreement), many employers have amended their plans to assign this discretion to the employer.
Under the Notice, however, even such employer discretion is impermissible. To correct such a documentation failure, the Notice requires that the plan or agreement be amended to remove the discretion entirely. Instead, the plan must provide that any payment will be made on the last day of the period allowed for signing the release or noncompete agreement. That period cannot be extended. Accordingly, if an employee fails to sign the release or noncompete agreement during the specified period, he or she must simply forfeit the deferred compensation.
Notice 2010-6 allows a plan to be amended to reflect this more stringent rule, but only if that amendment is adopted before the date of any distribution event to which the impermissible discretion relates. Thus, for instance, if an employment agreement conditions the payment of deferred compensation on the terminated employee signing a release of claims and/or a noncompete agreement, but does not sufficiently specify the date on which that deferred compensation will be either paid or forfeited, the employment agreement must be amended to specify this date before the employee separates from service. If it is not timely amended, the employment agreement would violate Section 409A, with the onerous tax consequences described above. For this reason, employers should promptly review their employment agreements to determine whether such corrective amendments might be needed.