Given the complex nature of the final regulations for Section 409A of the Internal Revenue Code (“Section 409A”), its broad scope, and the potentially severe tax consequences to service providers, the Internal Revenue Service (“IRS”) has recognized the need to provide a correction program under Section 409A. In December 2008, the IRS issued Notice 2008-113, which sets forth guidance on correcting certain operational failures and provides corresponding transition relief. Now, the IRS has issued guidance on correcting certain document failures and provided corresponding transition relief.
Notice 2010-6 — Document Correction Relief Issued
Generally. On January 5, 2010, the IRS issued Notice 2010- 6, which generally provides companies the ability to correct certain document failures under Section 409A. The document correction procedures will result in the reduction and, in many circumstances, the avoidance of the Section 409A tax penalties. Moreover, if corrections for certain document failures are implemented by 2010 year-end, the Notice provides that the tax penalties will not be incurred in such instances. Given this, the upcoming months are an important opportunity to revisit nonqualified deferred compensation arrangements (especially those of an acquired entity) and correct any existing document issues covered by the Notice.
Guidance on Section 409A Interpretation. In addition to providing the document correction procedures, Notice 2010-6 provides further enlightenment to practitioners on how the IRS views certain provisions of Section 409A. For example, the Notice addresses the timing of severance payments that are conditioned upon an execution of a release by the recipient and requires that such severance be paid at the end of a specified period regardless of when within that period the release is executed. We feel that this will cause many companies to revisit their employment and severance agreements to ensure compliance with this somewhat surprising and extremely technical position taken by the IRS.
Eligibility. In general, companies will be able to take advantage of the Notice 2010-6 correction procedures so long as (i) the company is not under examination with respect to nonqualified deferred compensation for any taxable year in which the document failure existed, and (ii) certain informational filings are made with the IRS.
Document Failures Covered. Notice 2010-6 addresses many common types of nonqualified deferred compensation document failures. Such document failures include, but are not limited to, the following:
- a plan provision that designates a payment event with an ambiguous or no definition;
- an impermissible definition of separation from service, change in control, or disability;
- a payment period longer than 90 days following a permissible payment event;
- a payment provision making timing of payment after a permissible payment event dependent upon an employee action, such as the execution and submission of a release of claims or noncompetition agreement;
- impermissible payment events;
- certain impermissible alternative payment schedules that provide for more than one time or form of payment upon the occurrence of a single type of permissible payment event;
- impermissible service provider or service recipient discretion with respect to a payment schedule following a permissible payment event;
- impermissible service recipient discretion to accelerate payment events;
- impermissible reimbursement or in-kind benefit provisions;
- no six-month delay of payment for specified employees; and • impermissible initial deferral elections.
Conclusion. While many companies performed an indepth review of their nonqualified deferred compensation arrangements in anticipation of the January 1, 2009 Section 409A compliance deadline, Notice 2010-6 is still a welcome piece of guidance from the IRS. Any document failures covered by the Notice should be corrected by companies in 2010 to reduce or avoid tax penalties for their service providers.
Deducting Contingent Bonus Compensation
Generally. On December 4, 2009, the IRS released a memorandum dated July 28, 2009, from the Office of Chief Counsel on when a company can take a deduction for contingent bonus compensation. The memorandum discusses a fact pattern in which a Year 1 bonus is paid out by a company within the first 2 ½ months of Year 2, with payment contingent on the recipient being employed by the company on the date of payment. The IRS states that in such a situation, the tax deduction should be taken by the company in Year 2, because the “all events” and “economic performance” tests are not satisfied in Year 1. Although not addressed in the memorandum, the IRS guidance may not apply in situations where a company is still legally obligated to pay out a bonus (for example, due to state law), even if the criterion of being employed through the date of payment is not met.
Conclusion. Companies with contingent bonus arrangements similar to those discussed by the IRS in its guidance should make sure they are taking deductions in the correct year.