The Internal Revenue Service has issued important guidance allowing employers to correct failures in deferred compensation documents to comply with Section 409A of the Internal Revenue Code ("Section 409A"). Early correction is rewarded under this guidance by a significant reduction or elimination of the severe tax penalties that apply if a deferred compensation arrangement violates Section 409A.

Nonqualified deferred compensation arrangements must comply with the Section 409A rules both in form and operation. Previously, the IRS had issued relief under Notice 2008-133 (superseding prior guidance) only for operational noncompliance with the Section 409A rules. The new Notice 2010-06 (the "Notice"), scheduled to be published on January 19, 2010, provides the long-awaited guidance for correction of documentary noncompliance, offering the opportunity to employers and employees (or other service providers) to avoid or reduce Section 409A penalties.

2010 Correction. Notably, the Notice provides that correction of certain document defects (and any related operational failures) by December 31, 2010 may avoid all Section 409A tax penalties. Accordingly, all employers should take time early this year to review their existing compensation arrangements with employees, former employees and other service providers, to ensure that all such arrangements have been brought into compliance with the Section 409A rules.

Prospective Correction. Under the Notice, certain document failures (impermissible payment events, periods and schedules, and failure to include a 6-month delay in payment for specified employees) may be corrected, with the result that if the corrected plan provision does not affect the operation of the plan within one year after the correction date, there may be no inclusion in income or penalties. The one-year trailing period which starts at the date of correction is even greater incentive for your early review of your deferred compensation documentation. If the corrected plan provision does affect the operation of the plan within one year after the correction date, then the amount includable in income is generally reduced 50%–75%, depending on the type of correction (e.g., for the correction of an impermissible change in control payment event, by 75%). The Section 409A penalties would apply based on the reduced amount. The Notice also allows correction of impermissible initial deferral election provisions under certain circumstances. If the plan at issue is the employer's first plan of that type (disregarding certain exempt or terminated plans), then Notice 2010-6 relief may allow correction without any inclusion in income or penalties, if the failures are corrected by the later of the end of the year or 2-1/2 months after the first legally binding right arises under the plan. Any corrections made in reliance on the Notice must be reported to the IRS by both the employer and the employee or other service provider.

Clarification re Plan Language. Notice 2010-6 provides clarification that certain ambiguous terms commonly found in compensation documents will not by virtue of their use cause a document failure, provided that there is no pattern of interpreting the terms in a manner inconsistent with Section 409A requirements and there is no noncompliant related language. For example, the payment timing phrase "as soon as reasonably practicable" is permissible, so long as payment is actually made by the later of the end of the calendar year or 2-1/2 months after the payment event. Also, permissible payment events with no definition or ambiguous definitions, such as "termination of employment" or "acquisition", may be permissible, but not where the document contains noncompliant related language such as, for example, "acquisition" provisions including events outside of the Section 409A change in control definition.

Further Clarification re Operational Violations. In addition, the Notice provides clarification of certain issues arising under Notice 2008-113, which addresses the correction of certain operational failures, including clarification of the appropriate correction for late payments and the calculation of corrective payments made in property, such as shares of stock.