On January 5, 2010, the Internal Revenue Service (the “IRS”) issued Notice 2010-6, permitting taxpayers to voluntarily correct certain failures to comply with the documentary requirements of Section 409A of the Internal Revenue Code. Section 409A governs nonqualified deferred compensation, and the failure to comply with its provisions can result in immediate inclusion of such deferred amounts in the income of the service provider (referred to below as the employee), an additional 20% tax and interest penalties. Notice 2010-6 also helpfully clarifies that the use of certain ambiguous plan terms are not document failures at all if the plans are operationally in compliance with Section 409A.

The documentary failures that Notice 2010-6 addresses include:

  • The use of an impermissible definition of “separation from service,” “change in control” or “disability”;
  • The designation of a period longer than 90 days (and less than one year) during which payments can be made or commence following a permissible payment event;
  • The use of impermissible payment events and impermissible payment schedules;
  • Impermissible reimbursements or in-kind benefits;
  • The failure to include a six-month delay for payments to “specified employees”; and
  • The use of impermissible initial and subsequent deferral elections.

Notice 2010-6 provides special transitional relief for document failures covered by the notice that are corrected by December 31, 2010. Therefore, it is important for clients to identify and fix these document failures before the end of the year. In general, if a nonqualified deferred compensation plan contains document failures covered by Notice 2010-6, and the plan is corrected in accordance with Notice 2010-6 on or before December 31, 2010, and before any payment is made that should not have been made or payment is not made that should have been made, the plan will be treated as having been corrected on January 1, 2009, for purposes of the correction procedures in the notice, with the result being that no amounts will have to be included in income under Section 409A or subject to the additional 20% tax or premium interest tax. However, to be eligible for this special transition relief, any payment made before December 31, 2010, that would not have been made under the amended plan (or any payment not made before December 31, 2010, that would have been made under the amended plan) must be treated as an operational failure and corrected under the procedures set forth in Notice 2008-113 for the correction of operational failures (which may require certain employees who are insiders to include an amount in income under Section 409A and pay an additional 20% tax).

Document failures covered by Notice 2010-6 may be corrected after December 31, 2010, but, in that case, if the corrected plan provision affects the operation of the plan within one year after the correction date the affected participants will have to include in income a specified percentage of the amount they otherwise would have had to include under Section 409A, plus the additional 20% tax on that amount, but not any premium interest tax. Depending on the type of correction, the specified percentage is generally either 25% or 50%, i.e., a reduction of 75% or 50%.

Companies may also correct certain document failures without current income or additional taxes under Section 409A if the plan is the company’s first plan of that type (disregarding any plans not subject to Section 409A or any plans under which all deferred amounts have previously been paid or forfeited) and the failure is corrected by the 15th day of the third calendar month following the end of the calendar year in which the right to deferred compensation vested under the plan.

Notice 2010-6 also requires that companies take commercially reasonable steps to identify all other nonqualified deferred compensation plans that have a document failure that is substantially similar to the failure initially identified and corrected and correct all such failures in a manner consistent with the notice. Any corrections must be reported to the IRS by both the company and the employee.

Notice 2010-6 is lengthy and contains numerous examples and explanations. The following is a summary of those examples and explanations we believe are most relevant to our clients. Please contact any member of Hogan & Hartson’s Employee Benefits and Executive Compensation Department for information on other correction methods identified.

  • “As soon as practicable.” Notice 2010-6 clarifies that providing for a payment “as soon as practicable” following a permissible payment event generally will not cause a document failure under Section 409A so long as the company does not have a practice of making payments following the later of the end of the employee’s taxable year in which the payment event occurs or the fifteenth day of the third calendar month following the permissible payment event. Similarly, providing for a payment upon an employee’s “termination of service” (without including a definition of “termination of service”) will not cause a document failure under Section 409A so long as the company has a practice of only making payments upon a “separation from service” within the meaning of Section 409A.
  • Non-Compliant Definitions of “Separation from Service.” If a plan contains a non- 409A compliant definition of “separation from service” (for example, incorrectly providing that a transfer to an 80% owned subsidiary of the employer constitutes a separation from service for an employee of that employer, entitling the employee to payments under an agreement), Notice 2010-6 allows the plan to be amended to provide for a definition of separation from service that is compliant with Section 409A. The correction must be made before the earlier of the date an event occurs that would not be a separation from service under Section 409A but is a payment event under the plan, or the date an event occurs that is a separation from service under Section 409A but is not a payment event under the plan. The amendment must be effective immediately. Unless corrected in 2010, if, within one year following the date of correction, an event occurs that is not a separation from service under Section 409A but would have required payment under the pre-correction plan version, or that is a separation from service under Section 409A but would not have required payment under the pre-correction plan provision, and results in the corrected plan provision being applied to avoid a payment that would have been due under the precorrection plan provision, or make a payment that would not have been due under the pre-correction plan provision, 50% of the amount deferred under the plan to which the pre-correction plan provision would have applied must be included in income under Section 409A (resulting in an additional 20% tax on that amount) by the employee in the year in which the event occurs.
  • Non-Compliant Definitions of Change in Control Events. If a plan contains a non- 409A compliant definition of a change in control event (such as, for example, the successful completion of an initial public offering), Notice 2010-6 allows the plan to be amended before the date an event occurs that is not a change in control event under Section 409A but is a payment event under the plan, to provide for a change in control event definition that satisfies Section 409A, provided that the amendment may not cause an event that was not a payment event under the original terms of the plan to become a payment event under the plan. The amendment must be effective immediately. Unless corrected in 2010, if, within one year of the date of the correction, a transaction occurs that is not a change in control event under Section 409A and results in the corrected plan provision being applied to avoid a payment that would have been due under the pre-correction plan provision, 25% of the amount deferred under the plan to which the pre-correction plan provision applies must be included in income under Section 409A (resulting in an additional 20% tax on that amount) by the employee in the year in which such event occurs.
  • Payments Contingent on Execution of a Release of Claims. The Notice 2010-6 includes a correction for certain situations in which severance payments are contingent on a release of claims and the employee has the ability to control the timing of the severance payments by determining when to sign the release. This would generally be a problem only if the period during which the release could be effective and payments be made exceeds 75 days after separation from service (i.e., payments would not necessarily be made or commence during the short term deferral period.) For example if a severance agreement provides that an employee is entitled to payments upon a separation from service, payable within 90 days of the separation from service, but not until the employee executes a release of claims and the applicable revocation period has expired, the IRS determined that this arrangement is in violation of Section 409A because of the potential, when the 90-day period overlaps two taxable years, for the employee to control the year in which the severance payments commence by timing when he returns his release to the employer. Notice 2010-6 allows this to be corrected without any amount having to be included in income (or any 20% additional tax) as long as the correction is made before separation from service. The proper way to correct it depends on whether the severance agreement or plan currently requires payments to be made within a 90- day (or shorter) period following separation from service. If it does, the severance agreement or plan must be amended to provide that the severance payments will be made at the end of the relevant period following separation from service (if the release is effective by then). If it does not, the severance agreement or plan must be amended to provide that the payments will be made either on the 60th or the 90th day period following separation from service (if the release is effective by then).
  • Plans with Permissible and Impermissible Payment Events. If a plan has both an impermissible and permissible payment event (for example, payment upon the earlier of an initial public offering (impermissible event) and payment upon a good 409A separation from service (permissible event)), Notice 2010-6 allows the plan to be corrected before the date of the occurrence of the impermissible payment event by amending the plan to remove such event. Unless corrected in 2010, if, in the year following the amendment there is an occurrence of the event that would have been an impermissible event under the pre-corrected plan, the employee must include 50% of the amount deferred in income under Section 409A (resulting in an additional 20% tax on that amount).
  • Plans with only Impermissible Payment Events. If a plan’s payment event is only one or more impermissible payment events (such as payment upon an employee’s child commencing college), Notice 2010-6 allows the plan to be corrected before the impermissible payment event occurs, by amending the plan to remove the impermissible payment event or events and providing that payment will commence on the later of the participant’s separation from service (within the meaning of Section 409A) and the sixth anniversary of the date of correction. Unless corrected in 2010, the employee will be required to include 50% of the amount deferred under the plan in income under Section 409A in the year in which the correction occurs (resulting in an additional 20% tax on that amount).
  • Plans of Public Companies that Fail to include the Six-Month delay for “Specified Employees.” Notice 2010-6 allows a plan to be corrected before the date an event occurs that would be subject to the six-month rule by adding the six-month delay and providing that an amount payable under the plan subject to the six-month rule cannot be paid before the later of (1) 18 months following the date of correction or (2) six months following the date of the payment event. Unless corrected in 2010, if a specified employee of a public company has a separation from service within one year of the amendment, resulting in application of the corrected plan provision, 50% of the amount deferred under the pre-corrected plan provision must be included in the employee’s income (resulting in an additional 20% tax on that amount).