The IRS has issued guidance on correcting documentary errors to bring nonqualified deferred compensation plans into compliance with the requirements of Internal Revenue Code Section 409A. Notice 2010-6, issued January 5, 2010 offers welcome relief from certain common drafting errors, but it is not comprehensive.
Notice 2010-6 confirms that certain plan language that may seem to be innocuous may in fact violate Section 409A. It also offers reassurance that certain commonplace terms, such as "termination of employment," while ambiguous, do not automatically violate Section 409A. In addition, the Notice offers a means to correct certain documentary failures without penalty, so long as the document is amended to correct the error in advance (generally 12 months in advance) of an event that would have caused a Section 409A violation if the erroneous provision had been triggered in operation. If the error is not corrected sufficiently in advance, a significant penalty applies (generally immediate income inclusion and a 20% tax penalty (but no premium interest tax) on 50% of the amount that would have been included in income had no documentary correction be made).
Most importantly, under the Notice, documents may be amended any time in 2010 to correct the errors enumerated in the Notice retroactive to January 1, 2009, without penalty. However, if a violation of Section 409A occurs pursuant to the unamended document prior to the correcting amendment (such as a distribution to a specified employee in violation of the six-month delay rule) the violation is treated as an operational violation and corrected in accordance with Notice 2008-113, the IRS guidance on correcting certain operational failures to comply with Section 409A. Additional transitional relief is offered for certain corrections to plans linked with tax-qualified retirement plans if made no later than December 31, 2011.
In order to be eligible to correct documentary errors pursuant to Notice 2010-6, including errors corrected under the transition relief, both the employer (service recipient) and the employee (service provider) must attach a specified disclosure schedule to their original tax returns for the year of the correction and in some cases the following year also.
A detailed description of the correction process is beyond the scope of this alert. However, this checklist of correctable plan provisions may be a useful spur to a thorough review of documents that might be subject to Section 409A, including those previously amended to reflect the requirements of Section 409A:
Examples of documentary errors eligible for correction:
- Use of ambiguous terms, such as "as soon as practicable" or "termination of employment" (if the plan contains a provision requiring it to be construed and administered in compliance with Section 409A, no amendment to the document may be required).
- Impermissible definition of "separation from service," such as a move from one subsidiary to another, or a change from full time to part time or independent contractor status.
- Impermissible definition of "change in control" where change in control is a payment trigger.
- Noncompliant definition of "disability" where disability is a payment trigger.
- Payment period of more than 90 days after a triggering event.
- Making the time of the payment dependent on when the employee (service provider) signs a release, even if there is a limited time period (such as 60 days) during which the release may be signed.
- Impermissible payment events. (The actual correction depends on whether only some or all the payment events are impermissible under Section 409A.)
- Timing of payment of deferred compensation on separation from service varies, such as a lump sum payment on a voluntary separation and installments on an involuntary separation, or a lump sum payment if the employee is a vice president or above on separation, and installments otherwise.
- Employer or employee discretion to change the time or form of payment (other than in accordance with the permitted acceleration rules under Treas. Reg. Section 1.409A-3(j)), or impermissible subsequent deferral elections such as employer discretion to accelerate installment payments to a lump sum, or employer discretion to extend payments over time if certain cash flow targets are not met.
- Impermissible reimbursement or in-kind payment provisions, such as a provision for reimbursement of country club dues, up to an aggregate of $100,000 over a five-year period after separation.
- Failure to provide for six-month delay in payments triggered by a separation from service of a specified employee.
- Impermissible initial deferral elections.
Generally, documentary errors involving stock rights (options and stock appreciation rights) are not correctable under Notice 2010-6. Also, documents that are intended to be exempt from Section 409A by providing exclusively for short-term deferrals or other exempt payments that inadvertently provide for deferred compensation subject to Section 409A are not eligible for correction under the Notice.
Many employers and other service providers will want to take advantage of the transition relief in Notice 2010-6 to revise documents providing for payments subject to Section 409A.