Correction Appended

When Congress added section 409A to the Internal Revenue Code (IRC), it also imposed stiff penalties for failures to follow the rules. So, if clients make any mistakes in operating nonqualified deferred compensation (NQDC) plans, such as forgetting to actually deduct deferred amounts from executive’s paychecks, those executives could face big unexpected tax bills.

Now there is a way that companies can avoid having those penalties imposed on executives for the firm’s unintentional mistakes in operating NQDC plans.

Last December, the Internal Revenue Service (IRS) issued guidance detailing how section 409A NQDC programs can fix certain types of plan problems. If certain procedures are followed, participants, i.e., company executives, will not incur the rather draconian tax penalties. Essentially, the new guidance allows employers to correct a problem voluntarily, says Michael Melbinger, a partner with Winston & Strawn LLP in Chicago. “You don’t have to try to sweep the problem under the rug and lose sleep over it,” he says.

While the correction program is a good thing, it could be better. “It’s a good thing but it’s just a start,” says Brigen Winters, a Principal at the Groom Law Group in Washington. It’s a preliminary step toward what companies need, he says, particularly after the transition period for 409A applicability ends at the end of this year.

Part of the problem is that the scope of the program is very limited, says Bruce Ashton, a Partner with Reish Luftman Reicher & Cohen in Los Angeles. “That said, it’s better than nothing,” he comments.

Advisers need to be aware that the relief is available, says Ashton. If advisers are proactive and observe what is going on and a problem crops up, then they can help fix the problem. “If they find out that something hasn’t happened in an NQDC plan, and if they know the [correction] rules, they can go to the client and say, “We can fix that,”” he says.

For the last few years, advisers have been focused on getting NQDC plans in compliance with section 409A, says Melbinger. This notice, he says, adds another item to advisers’ “to do” lists, because, in order to take advantage of the program, there need to be procedures in place so that operational errors do not occur. “It’s not onerous, but it has to be done,” he says.

The voluntary correction program is detailed in Notice 2007-100. In this notice, the Treasury Department and IRS outlined a procedure that gives firms the ability to correct operational failures to comply with section 409A of the IRC. Section 409A was signed into law as part of the American Jobs Creation Act in 2004 to address concerns over reported abuses in NQDC plans. Specifically, Section 409A now states that distributions from NQDC plans may be made only after: (1) separation from service; (2) disability; (3) death; (4) a period of time specified in the plan or election; (5) change of control or change in ownership of corporate assets; (6) unforeseeable emergency. Distributions to top executives are limited further. If an officer making more than $130,000 or a 1% owner with compensation greater than $150,000 separates from service, he may not get distributions for six months. In 2006, the IRS extended the date for compliance with the new section 409A rules through the end of 2007.

Specifically, Notice 2007-100 implements a voluntary correction program for 409A plans and provides relief for certain unintentional operational failures that are corrected in the same year—for example, an unintentional failure to comply with plan provisions that satisfy the requirements of section 409A or an unintentional failure to follow the requirements of section 409A in practice. If the operational failure is corrected in the same taxable year, then participants do not incur a taxable event.

Essentially, if a 409A program has an unintentional operational error that is detected and corrected on a timely basis, then executives may not be subject to penalties. Not only does the failure have to be unintentional, it cannot be a shortcoming in the plan document language, but in the actual running of the plan itself. Relief is not available with respect to any intentional failure to comply with the terms of a plan or the requirements of section 409A in the operation of the plan.

Additionally, relief is not available unless, in addition to correcting the operational failure, reasonable steps are taken to avoid a recurrence of the operational failure. Relief may not be available if the same or a substantially similar operational failure occurred previously.

Furthermore, not all operational errors qualify for relief. Operational failures that qualify for relief include the failure to actually defer the amounts or incorrect payments. For example, if a company accidentally pays the executive amounts that should have been deferred into the plan, then, as long as the employee repays the money in the same tax year, the correction is recognized.

Relief is also available for amounts erroneously paid to an employee from the plan if the money is repaid. For example, if an employee is scheduled to receive $10,000 from a nonqualified plan but is mistakenly paid $11,000, then relief is available upon repayment of the $1,000.

If amounts are erroneously deferred into the plan, then relief is also available. For example, if an employee elects to defer 10% of a $100,000 bonus, and the employer mistakenly defers $50,000 into the plan, the excess $40,000 will not be treated as deferred if the employer corrects the error and pays the employee the $40,000.

Relief is not available if the plan itself does not meet the requirements of section 409A and any guidance related to it. Relief is also not available if the operational failure is “egregious,” or related to the participation in an “abusive tax avoidance transaction.”

Limited Scope

There are also strict limitations on when corrections can be made. Generally, operational failures only can be corrected within the same tax year. Thus, a problem that occurs in March 2008 and discovered in May 2008 is correctable without penalties. One made in December 2008 and discovered in January 2009 may not be.

However, until 2010, when this relief is no longer available unless extended, if an operational failure is not discovered until after the end of the tax year, the executive affected by the failure may not be liable for the premium interest penalty taxes, but he might still be liable for the 20% penalty tax. For example, an employee elects to defer 8% of a 2007 $10,000 bonus into the plan, but the employer defers 10% into the plan. The mistake is not discovered until 2008, at which time the account balance includes $15 earned on the excess $200 credited to the account. The employer can pay the employee $215. In addition to income taxes, the employee is required to pay the additional 20% penalty tax on the $215, but not the premium interest tax. The total amount cannot exceed the limit on 401(k) deferrals, i.e., $15,500 for this year. The small amount limit ($15,500) reduces the availability of this relief quite a bit, notes Winters.

The voluntary correction program is not available in any year that the employer is in a “substantial financial downturn’ or “otherwise experienced financial or other issues that indicated a significant risk.’ The IRS has not yet defined what this means and one can argue the current economic environment is such that all firms this year are in a financial downturn, meaning relief is not available, says Ashton.

Any business that takes advantage of this voluntary correction program relief must file, along with its federal income tax return for the taxable year in which the failure occurred, notice to the IRS. The notice must be entitled “Section 409A Relief Under Section II of Notice 2007-100.”

Although limited, it is understandable why the IRS would take such a cautious approach, says Ashton. In the past, when the IRS introduced voluntary corrections programs for qualified plans, he says, the service took a similar cautious approach. “All the corrective programs started out as limited-scope experimental programs,” he says.

The IRS asked for comments on the program, although the comment period ended March 3, and will probably issue more guidance in the near future, maybe as soon as this fall, say the experts. The IRS already is signaling that it may broaden this policy, says Winters. For example, he says, it asked for comments about extending relief for transactions in another tax year above $15,500.

Additionally, one reason why the IRS has been so cautious in its approach to granting relief, says Winters, is that it is unsure if it has the statutory authority to go any further. Congress, however, has indicated that it is willing to provide the IRS with the authority. The Senate Finance Committee has attempted to add amendments to a bill for small-business tax relief and minimum wage legislation, although the amendment was dropped from the ultimate bill. Since then, says Winters, Senate Finance staff subsequently worked on possible amendments to this proposal, including a possible correction mechanism that could apply to failures to satisfy the 409A limit and possibly also to failures under current law 409A.

It’s hard to say how the program is working yet, says Winters. Few firms have used it at this point since nonqualified programs are still in a transition period. On the qualified plan side, Ashton says voluntary corrections programs are considered an enormous success.

In the end, all the experts agree that the notice is a step in the right direction. “It’s good that the rules are out there, although, for the time being, they have limited utility,” says Ashton.

After all, notes Winters, the penalties for violating section 409A are rather draconian. They include taxation of all amounts under all NQDC plans of the employer, not just the violated amounts, plus an additional 20% penalty tax and interest. Having some relief, even if it is only for certain errors, is a good thing.

*Illustration by Jillian Tamaki