The Internal Revenue Service has issued its long-awaited program for correction of errors in drafting nonqualified deferred compensation plans under Internal Revenue Code Section 409A.
Just as for the IRS program to correct Section 409A operational failures under Notice 2008-113, the document failure program provides specific rules for different types of failures, with different eligibility requirements, corrections and tax consequences for each.
The Notice includes a transition rule for 2010, permitting correction without the potential for adverse tax consequences that may apply when an error is corrected in a later year, and it includes certain revisions to Notice 2008-113 and the IRS guidance on reporting and withholding requirements under Notice 2008-115.
This article provides a brief overview of the detailed rules for correction of drafting errors under the Notice and offers a few initial observations on the program.
Designated errors
The program allows correction of the following drafting errors:
• Payment commencement date is ambiguous, such as “payment to be made as soon as practicable after death;”
• Event triggering payment is not defined or is ambiguous;
• Definition of separation from service, change in control or disability includes impermissible terms, such as treating a change from employee to independent contractor as a separation from service regardless of whether the hours worked decrease;
• Payment commencement date is later than permitted under the regulations;
• Either the service provider (generally, an employee) or the service recipient (generally, an employer) have impermissible discretion to vary the payment schedule or the employer may accelerate payment;
• Payment commencement is dependent upon employee signing a release or taking a similar action;
• Payment is to be made on impermissible event(s) or schedule(s);
• Provisions for reimbursements or in-kind benefits do not comply with the regulations;
• Six-month delay of payment rule for specified employees is not included in the plan; and
• Provisions for initial or subsequent deferrals do not comply with the regulations.
Playing by the rules
The program may only be used if (1) any drafting error was inadvertent and unintentional and does not involve a listed transaction; (2) once having discovered an error, the employer takes commercially reasonable steps to identify all plans affected by a similar error and to correct them all; (3) neither the employer nor the employee is under audit by the IRS with respect to nonqualified deferred compensation at the time of the correction, and; (4) the employee includes amounts in income, to the extent required, and pays the additional 20% tax, and the employer reports the amount includible in income.
Similar to the program for correcting operational failures, the Notice requires that an employer using the program attach a statement to that effect to its tax return for the year of correction, listing all of the employees whose plans were corrected. The employer must also provide a statement to each affected employee and advise them to attach it to their tax returns.
The program is available indefinitely for both existing plans and new plans that are adopted in subsequent years, though there is an incentive to take advantage of the program during 2010.
For certain types of errors, if corrective action is taken after the end of 2010, there may be adverse tax consequences under certain conditions. In contrast, during 2010, taxpayers who use the program generally will not need to include amounts in income, with one exception.
That is, if a corrective amendment is adopted during 2010 but a payment has been made, in 2010 or any earlier year, that would not have been payable under the amended plan, that improper payment must be treated as an operational failure and corrected under Notice 2008-113 no later than Dec. 31, 2010, which will likely result in some additional tax.
Tax consequences
As indicated above, there is a potential for adverse tax consequences in connection with certain types of corrections made after 2010, although the exposure generally only continues for one year after the corrective amendment is adopted, and the employer and employee will often be able to control whether the adverse tax consequences will apply.
For example, if a plan provides for payment upon separation from service but defines that term in a way that is impermissible under the regulations, the Notice allows adoption of a corrective amendment and no adverse tax consequences as long as an impermissible separation does not occur within one year after the amendment is adopted.
More specifically, assume the plan says payment will be made upon separation from service, including upon transfer from the parent company to a subsidiary. Since this type of transfer would not be a separation from service under the Section 409A regulations, the plan is amended to eliminate the transfer rule.
If the employee covered by the plan transfers to a subsidiary within one year of the date the amendment is adopted, the employee must include in income 50% of the amount he would have been entitled to receive upon the transfer and pay the 20% additional tax on that amount.
The Notice includes similar rules for corrections related to certain other impermissible payment rules or deferral rules in plans, with a special rule for correction of new plans no later than two and half months after the end of the year the plan is adopted.
Observations
• The Notice provides insights on the proper way to draft Section 409A plans — at least in the view of the IRS — and many employers will want to take advantage of the transition period to review their plans and make revisions if necessary during 2010.
• The IRS has invited comments on the Notice, and the authors of the Notice are already indicating a willingness to consider refinements to it.
• The IRS stance on how a payment that is conditioned on an employee signing a release must be structured to comply with the Section 409A regulations has caught many employers and their advisors by surprise.
• The IRS is aware that its correction for in-kind payments can produce harsh results but felt it was necessary to have a mechanical rule.
• The Notice is not intended to allow changes in the terms of plans — just an opportunity to make clean-up revisions.
Carol A. Weiser can be reached at carolweiser@sutherland.com.
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