Section 409A of the Internal Revenue Code imposes substantial additional taxes and penalties on nonqualified deferred compensation plans that fail to comply, in both form and operation, with Section 409A’s substantive provisions.
Limited Opportunity to Correct Section 409A Document Failures Without Penalty
In 2010, the Internal Revenue Service released Notice 2010-6, which allows taxpayers to voluntarily correct certain failures to comply with the documentary requirements of Section 409A. Until Notice 2010-6 was issued, it remained unclear whether documentary failures could be corrected without incurring penalties under Section 409A. Now, certain corrections are permitted to be made without incurring any adverse tax consequences but only until December 31, 2010. Although Notice 2010-6 permits corrections after December 31, 2010, the relief is limited and certain penalties may apply.
The Notice lists a number of criteria for a plan to be eligible for document correction, including the following:
- Only inadvertent or unintentional failures may be corrected.
- All similar failures must be corrected, including failures in other plans.
- The employee’s tax return must not be under examination and the employer’s tax return must not be under examination with respect to nonqualified deferred compensation.
- The employee must pay all taxes related to the Section 409A correction.
- The employer must satisfy information and reporting requirements.
Errors Eligible for Correction
Document failures that may be corrected pursuant to Notice 2010-06 include, but are not limited to:
- terms providing for ambiguous payment timing, such as “as soon as practicable” after a permissible payment event;
- documents providing a permissible payment event with no definition or an ambiguous definition;
- documents providing impermissible definitions of certain specific terms such as “separation from service,” “change in control” or “disability”;
- documents providing payment periods of longer than 90 days following a permissible payment event;
- plans with both permissible and impermissible payment events;
- plans with only impermissible payment events (for example, payment upon a child’s starting college);
- certain impermissible alternative payment schedules (for example, payment in a lump sum upon involuntary separation from service and payment in installments upon voluntary separation from service);
- impermissible employer discretion to accelerate payment;
- failure to include six-month delay of payment for specified employees of public companies; and
- impermissible initial deferral elections and subsequent deferral elections.
One “Sleeper” for Possible Correction
In Notice 2010-6, the IRS published for the first time a new restrictive interpretation of Section 409A relating to payments contingent on the employee taking some kind of action as a condition to receiving a payment.
- For example, it is common practice in the context of an employment or severance agreement to require the employee to sign a release of claims as a condition to receiving severance payments. Sometimes the payment is contingent on the employee signing restrictive covenants, such as an agreement not to compete or not to solicit customers or employees.
If the commencement date for severance payments is based on the date the employee signs and returns a release or noncompetition agreement, this could theoretically enable the employee to control which taxable year payments may commence (where the period for action spans a calendar year end). This potential control by the employee over the timing of payments causes the agreement to violate Section 409A, unless the payments are otherwise exempt from Section 409A.
To address this issue, many companies amended their severance agreements before 2009 to give the employer exclusive ability to determine when during the designated period the severance payment would commence, regardless of the time during the period the employee signed the required document. While this approach is technically condoned in Treas. Reg. §1.409A-3(b), IRS representatives have said unofficially that they do not think this is sufficient to solve the Section 409A issue, unless the company can point to actual examples in which it has paid severance before a terminated employee has signed a required release or other required document (which would be rare).
Notice 2010-6 indicates that, in order to comply with Section 409A, the document should specify that the severance payment will be made (if at all) on the last day of the identified period for the employee to take action (not to exceed 90 days). For example, if the employee has 60 days to sign a release, payment will be made on the 60th day, even if the release is signed earlier. Though the IRS may provide further guidance on this issue, correcting your agreements now to make them comply with Notice 2010-6 is the best way to be sure that any non-exempt severance payments are compliant on this confusing issue.
Why It Is Important To Act Now
Even companies that previously submitted their plans for detailed review should consider a secondary review now. Reviewing and correcting any inadvertent failures in 2010 can save your employees hefty tax penalties later. In addition to document amendments, correction of operational failures may be necessary, so it is important to allow enough time to complete the process.