On the TV show Futurama, the aged proprietor of the delivery company Planet Express, Professor Hubert J. Farnsworth, had a habit of entering a room where the other characters were gathered and sharing his trademark line, “Good news, everyone!” Of course, his news was rarely good. More often, it was the beginning of some misadventure through which the other characters would inevitably suffer, often to great comedic effect. So we can forgive you for thinking that we may be standing in his shoes when we tell you that new 409A regulations are good news, but really, hear us (read us?) out.
The IRS released proposed changes to both the existing final regulations and the proposed income inclusion regulations. And the news is mostly good. Additionally, taxpayers can rely on the proposed regulations.
The changes are legion, so we are breaking up our coverage into a series of blog posts. This last in our series is about the changes to the proposed income inclusion regulations and the other minor changes and clarifications made by the regulations. See our prior posts, “Firing Squad,” “Taking (and Giving) Stock,” “Don’t Fear the (409A) Reaper,” and “Getting Paid.”
Preventing Waste, Fraud, and Abuse (Okay, well, mostly just abuse). The only change to the proposed income inclusion regulations was to “fix” the anti-abuse rule that applied to correcting unvested amounts that violated 409A. “Why?” you might ask. Apparently, because people were abusing it.
Under the proposed income inclusion regulations, a broken (that’s a technical legal term) 409A arrangement could be fixed in any year before the year it would vest (what we will call “nonvested” amounts). The prior proposed regulations did not put many parameters on how the fix had to happen (other than it needed to, you know, comply with 409A).
Some hucksters (again, technical term) were apparently amending arrangements that complied with 409A to make them noncompliant. Then they would amend them again to “fix” them in the way they wanted. This would allow them to get around the change in election rules, as long as the amount would not vest that year. Clever, perhaps, but pretty clearly not within the spirit of the rules.
To prevent this kind of abuse, the IRS has revised this permitted correction rule. First, if there is no good faith basis for saying that the arrangement violates 409A, it cannot be fixed.
Second, the regulations provide a list of facts and circumstances for determining if a company has a pattern or practice of permitting impermissible changes. If they do, then they would not be able to fix a nonvested amount. The facts and circumstances include:
- Whether the service recipient has taken commercially reasonable measures to identify and correct substantially similar failures upon discovery;
- Whether substantially similar failures have occurred with respect to nonvested deferred amounts to a greater extent than with vested amounts;
- Whether substantially similar failures occur more frequently with respect to newly adopted plans; and
- Whether substantially similar failures appear intentional, are numerous, or repeat common past failures that have since been corrected.
Finally, the regulations require that a broken amount be fixed using a method provided in IRS correction guidance. This doesn’t mean that you have to use the correction guidance for unvested amounts. What it means is that, if a method is available and would apply if the amount was vested, then you have to use the mechanics of that correction (minus the tax reporting or paying any of the penalties). For example, under IRS Notice 2010-6, if a plan has two impermissible alternative times of payment for a payment event, it has to be corrected by providing for payment at the later of the two times. You would have to fix a nonvested amount in the same manner under these rules.
While these changes are intended to ferret out abusers of the rules, this does make it harder for well-intentioned companies who merely have failures to make changes.
Other Minor Changes and Clarifications. The proposed regulations also confirmed and clarified the following points of the current final regulations:
- 409A does apply to non-qualified arrangements of foreign entities that are also subject to 457A.
- Entities can be subject to 409A as service providers in the same way that individuals are.
- Payments can be accelerated for compliance with bona fide foreign ethics laws or conflicts of interest laws.
- On plan termination and liquidation outside a change in control, all plans of the same type (e.g., all account balance plans) have to be terminated. And no additional plans of that type can be adopted for three years. This is what the IRS always understood the rule to be, but they just made it clearer in these proposed regulations.
- Payments can also be accelerated, without limit, to comply with Federal debt collection laws.