What you need to know: The IRS recently announced a document correction program that allows taxpayers to correct drafting errors in nonqualified deferred compensation plan documents to comply with section 409A.
What you need to do: Clients should review nonqualified deferred compensation plan documents and determine whether any drafting errors have occurred. Any decision to correct any errors under the program should be implemented as soon as reasonably practicable, ideally by December 31, 2010.
Earlier this month, the IRS issued a Notice announcing a new program that allows for the correction of nonqualified deferred compensation plans that fail to comply with the documentation requirements of section 409A of the Internal Revenue Code. This new program works in conjunction with a similar relief program announced in late 2008 addressing certain failures to operate a plan in compliance with section 409A.
Recap of section 409A
Deferred compensation arrangements within the scope of section 409A are often included in employment agreements, change-in-control agreements, severance plans, bonus plans and equity compensation plans, as well as in traditional nonqualified deferred compensation plans (such as SERPs). Noncompliance with section 409A may result in severe tax consequences. Deferred compensation in a plan that is noncompliant in form or operation may be immediately taxable to the employee at regular income tax rates plus a 20% penalty rate, as well an interest charge. Moreover, an employer may have a tax withholding obligation as a result of the failure. Some plans have been drafted to avoid the scope of section 409A such as by providing that benefits are to be paid shortly after they vest. Others are governed by section 409A and must comply with numerous requirements specified in Treasury regulations.
Corrections available under the program
The document correction program applies only to plans (including individual arrangements) that are within the scope of section 409A. Not all document failures may be corrected. For example, the program does not provide relief for the correction of discounted stock options. Permitted document corrections may be made so long as failures are unintentional and, before corrections are completed, neither the employer nor the employee are under IRS examination with respect to nonqualified deferred compensation for any tax year in which the failure existed. Furthermore, the employer must take steps to identify similar documentation failures in other plans and make appropriate corrections for the other arrangements.
In most cases (except for corrections relating to ambiguous plan terms), the employee must recognize a percentage of the deferred amount as taxable income and pay the appropriate tax (including the 20% penalty, but not the interest charge, on such amount) if the plan’s operation is affected by the correction within one year after the correction. However, the Notice provides transition relief from the income inclusion requirement and 20% penalty for document corrections made during 2010, and in a few instances, during 2011. In addition, most document corrections (again, except for those relating to ambiguous plan terms) must be reported to the IRS. In general, document corrections must be made before an event occurs that triggers the operation of an offending plan provision, i.e., before an employee triggers an impermissible payment event, or before the employee incurs a permissible separation from service. Any intervening operational errors resulting from the failure to follow the corrected plan document are includible in income and subject to the notice and reporting obligations under the correction program for operational errors.
Below are some important document corrections available under the program:
- Ambiguous plan terms: The Notice provides that certain ambiguously defined plan terms relating to the timing of payments and permitted payment events will not automatically result in a violation of section 409A. For example, a plan that uses the phrase “as soon as reasonably practicable” to identify the timing of payment after a permissible payment event (such as a separation from service within the meaning of section 409A) generally will not cause the plan to violate section 409A and need not be amended, despite the vague nature of the phrase, as long as the payment is actually made by the later of the end of the calendar year in which the event occurred or the fifteenth day of the third calendar month following the permissible payment event. In addition, plans with payment events that are either not defined or ambiguously defined generally will not violate section 409A and may be amended at any time for clarification. For example, the use of the phrase “termination of employment” to describe the section 409A permitted payment event of separation from service could be interpreted to mean a separation from service within the meaning of section 409A or an impermissible payment event (such as a change of employment from a parent to a subsidiary corporation). The plan may be amended to add language requiring that the terms of the plan be interpreted as necessary to comply with section 409A, or amended to incorporate an explicit definition that qualifies as a separation from service (including by cross-reference to the relevant Treasury regulation section).
- Correction of impermissible definitions of payment events: Subject to certain conditions, corrections may be made to plan documents that provide for payment upon events that do not qualify as a “separation from service,” a “change in control” or a “disability” as those terms are defined in Treasury regulations. For example, a change in status from full-time employee to full-time independent contractor does not qualify as a “separation from service” under section 409A, and therefore payment of deferred amounts may not be made upon such change in status. In this case, the plan may be amended before the impermissibly defined event or a 409A separation from service occurs to remove the employee’s change in status to independent contractor as a payment event. If within one year following a document correction made after December 31, 2010 an event occurs that would trigger the deleted impermissible payment event or constitute a separation from service under section 409A, the employee must pay income taxes on up to 50% (depending on which definition of payment event was incorrect) of the amount that would have been payable under the pre-corrected plan and pay the 20% penalty tax.
- Correction of impermissible payment periods: Employment or severance agreements commonly provide for payment to be made upon a section 409A permissible payment event (such as separation from service) on the condition that the employee sign a non-compete or release of claims. While such conditions are not prohibited under section 409A, they must not have the effect of allowing an employee to delay or accelerate payment. For example, a separation agreement that allows an employee to defer payment to a subsequent calendar year by simply delaying the execution of a release violates the requirement that payment be made within a permissible payment period. Separation agreements may be corrected by removing the ability of the employee to delay or accelerate the timing of the payment based upon the employee’s actions by setting a fixed payment date (the last day of the payment period if a period is designated, or if none either 60 or 90 days) following the separation from service, provided that the employee has executed and submitted a release of claims and the statutory period during which the employee is entitled to revoke the release has expired before the fixed payment date. In this situation, a correction prior to a separation from service will avoid the payment of any additional taxes or penalties. The program also includes procedures for correcting plans that provide for payments to be made at the discretion of the employer at any time that is more than 90 days (but no more than one year) following a permissible payment event.
- Correction of impermissible payment events: Various document errors relating to payment events and schedules that cause a plan to violate section 409A may be corrected under the program. Among the plan terms that may be corrected include those that allow for impermissible payment events or those allowing for more than a single time or form of payment upon the occurrence of a permissible payment event. Other erroneous provisions that may be corrected are those relating to payment of reimbursement or in-kind benefits that run afoul of the section 409A payment timing rules. For each of these situations, special requirements apply to the timing and method of correction, and in some cases occurrence of the impermissible payment event within one year following a correction made after December 31, 2010 requires the employee to pay taxes on 50% of the amount deferred to which the pre-correction plan provision would have applied and the 20% penalty tax.
- Failure to include six-month delay of payment for specified employees: Certain executives of public companies must wait a minimum of six months after separation from service before receiving a distribution under a plan covered by section 409A. By its terms, the plan documentation must provide for this six-month delay. Plans that are missing the six-month delay provision may be corrected under the program. If a plan is amended to add the six-month delay provision prior to the separation from service, payments may not be made before the later of 18 months after the correction date or six months after the executive’s separation from service. If a specified employee has a separation from service within one year following a correction made after December 31, 2010, the employee must pay income tax on 50% of the amount deferred under the plan that is delayed due to the correction and the 20% penalty tax.
Reporting corrections to the IRS
As noted above, except for the correction of ambiguous plan terms, employers and employees must report most corrections to the IRS by attaching a statement to their respective tax returns for the year of the correction, as well as any subsequent year in which the employee is required to include deferred amounts in income. The Notice outlines the specific information required to be disclosed to the IRS.
The document correction program provides some of the much needed relief from penalties arising from certain common section 409A violations. The program contains numerous qualifications and conditions, as well as other available corrections, not discussed above. Other strategies, such as corrections for non-vested amounts, may also be available.