If your company has a nonqualified deferred compensation arrangement, you may want to have it reviewed by legal counsel or other tax professional before year end. The IRS has offered enhanced tax relief for document corrections made by December 31, 2010, but has indicated this is the last best chance to reduce or entirely avoid early income inclusion and penalty taxes.
Since 2004, the IRS has published complex regulations under Section 409A of the Internal Revenue Code (“409A”) which must be followed by nonqualified deferred compensation plans. The term “nonqualified deferred compensation plan” includes any arrangement which provides for the deferral of compensation, which is not a “tax-qualified” plan (such as a 401(k) plan), and which is not excepted under the IRS rules. Compensation to be paid from a 409A plan which is not in compliance with the requirements of 409A is subject to a 20% penalty tax, an interest penalty tax, and income tax inclusion in the year when there no longer is a substantial risk of forfeiture.
Plan documents were required to be in compliance by January 1, 2009. Many employers did not realize they had an arrangement subject to 409A or that any changes were required to their plans. For example, many employment and severance agreements are subject to the rules. Even those employers who made an effort to ensure their plans were updated may have provisions in those documents which the IRS has recently clarified are not in compliance with 409A.
In Notice 2010-6, the IRS listed some common plan provisions which the IRS views as technical errors:
- Conditioning the timing of a deferred compensation payment to the employee’s signature on a release of claims, non-competition agreement, or non-solicitation agreement,
- Linking the timing of a deferred compensation payment to an initial public offering or financing arrangement, and
- Impermissible payment period following otherwise permissible payment event.
In Notice 2010-6, the IRS provides guidance for taxpayers to voluntarily correct document failures. If document failures eligible for correction are fully corrected in accord with Notice 2010-6, the employer won't be required to report and the employee won't be required to include any amount as income for any year before the tax year in which the failure is properly corrected, and in some cases, taxpayers completely may avoid or reduce current income inclusion and penalty taxes.
Employers may wish to review their plans with legal counsel or other tax professional to determine if they meet IRS requirements. If documents are not in compliance with IRS requirements, employers should discuss the correction options with their tax advisors to determine if any are appropriate. If amendments are appropriate, we would strongly urge employers to get these done in 2010 to reduce or entirely avoid penalties where possible.