The Treasury Department and the IRS have issued relief and guidance (“Notice 2010-6”) on the correction of certain documentary failures of nonqualified deferred compensation plans. Numerous examples throughout the guidance illustrate various types of documentary failures and their related corrections. Taxpayers may rely on the guidance for taxable years beginning on or after January 1, 2009. Transitional relief within the guidance allows taxpayers to correct document failures by December 31, 2010 and avoid the punitive tax consequences that might otherwise apply.
Section 409A of the Internal Revenue Code (“Section 409A” or “§ 409A”) generally provides that, unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan are currently includible in gross income, to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Amounts includible in income under Section 409A are subject to two additional taxes—a 20 percent additional tax and a premium interest tax. Thus, failure to comply with the requirements of Section 409A results in severely adverse tax consequences for employees and other service providers who participate in a noncompliant deferred compensation plan.
A nonqualified deferred compensation plan must comply with the requirements of Section 409A both in operation and in form. In December 2008, the Treasury Department and the IRS issued Notice 2008-113, permitting the correction of certain operational failures (the “2008 Notice”). In January 2010, the Treasury Department and the IRS followed up with Notice 2010-6, permitting the correction of certain documentary failures (the “2010 Notice”). Both Notices provide guidance on limiting or excluding the amount includible in income under Section 409A.
Types of Relief
The 2010 Notice provides either:
- “penalty-free relief” with no Section 409A income inclusion or additional taxes being imposed; or
- “limited relief” with 50 percent (or 25 percent in one case) of the amount deferred under the plan (prior to its correction) being includible in income under Section 409A and subject to the 20 percent additional tax, but not the premium interest tax.
Please refer to our prior newsletter for the relief provided for corrections of operational failures in accordance with the 2008 Notice (subject to modifications made by the 2010 Notice, as discussed below).
Correction Procedures for Documentary Failures
The “Correction of Documentary Failures Table” at the end of this article summarizes the correction procedures and type of relief for 15 types of documentary failures described in the 2010 Notice.
Before issuance of the 2010 Notice, the Section 409A income inclusion guidance provided taxpayers with an opportunity to correct documentary failures, provided such correction is made prior to the year in which the deferred amount eventually vests. It appears that this correction method continues to be a viable alternative for addressing certain documentary failures.
A taxpayer is eligible for penalty-free or limited relief if the applicable correction procedures described in the 2010 Notice are satisfied and all of the applicable conditions below are satisfied:
- a service recipient takes commercially reasonable steps to identify and correct all of its plans containing substantially similar documentary failures;
- for any taxable year in which the document failure existed, the federal tax return of an individual service provider is not under examination and the federal tax return of the service recipient is not under examination with respect to any nonqualified deferred compensation issues;
- The federal tax return of a nonindividual service provider must not be under examination with respect to any nonqualified deferred compensation issues;
- A nonindividual service recipient whose federal tax return for years beginning on or before December 31, 2011 is under examination for nonqualified deferred compensation issues may still apply the corrections under the 2010 Notice, provided the specific document failure has not been identified as an issue in the examination.
- the document failures for which relief is sought are inadvertent and unintentional, and not related to participation in any listed transaction;
- relief is not sought for stock options or stock appreciation rights or, except as provided in the 2010 Notice, linked plans; and
- The 2010 Notice provides transition relief for corrections made on or before December 31, 2011 with respect to linked nonqualified deferred compensation plans and payment schedules determined by the timing of payments received by the service recipient. Generally, any amounts paid under the plans pursuant to the precorrection provisions after 2008 (or inconsistent with the amended provisions), must be treated as operational failures and corrected under the 2008 Notice.
- the information and reporting requirements are filed in a timely manner (e.g., Form W-2/1099 reporting and additional reports attached to the service recipient’s and service provider’s federal tax returns).
- Similar to the additional reporting requirements under the 2008 Notice, the service recipient must notify the IRS of the documentary correction by (1) attaching to its original federal income tax return for the year of correction (and the subsequent year if the service provider has related income inclusion during that year) a statement that identifies the plan, names the affected service providers, states the amount involved in each failure and makes specific representations regarding the eligibility for correction, and (2) furnishing a similar statement to each affected service provider (specific to each individual’s deferred amount), which must be attached to the service provider’s federal income tax return for the year of the correction (as well as the return for the year of income inclusion).
- The additional reports are not required for errors listed in the first two rows of the “Correction of Documentary Failures Table.”
Relief for Newly Adopted Plans
The 2010 Notice allows certain document failures to be corrected without Section 409A income inclusion or additional taxes if (i) the plan is the service recipient’s first plan of that type and (ii) the failure is corrected by the end of the calendar year in which (or, if later, two and a half months following) the date the first legally binding right to deferred compensation arose under such plan.
The 2010 Notice provides transitional relief by allowing certain document failures to be corrected without Section 409A income inclusion or additional taxes if the document failure is corrected by December 31, 2010, and any operational failures resulting from the document failure are also corrected in accordance with the 2008 Notice by December 31, 2010.
Modification of the 2008 Notice
The 2010 Notice also modifies the 2008 Notice (pertaining to operational failures) by clarifying:
- the amount that must be repaid by a service provider as a correction of an early payment of an amount deferred under a plan if taxes were withheld on the amount erroneously paid;
- the amount that must be repaid by a service provider as a correction of an early payment of an amount deferred under a plan if the early payment was made in property; and
- the amount that must be paid to the service provider as a correction of a late payment of an amount deferred under a plan if the payment would have been made in property.
In light of the favorable transition relief under the 2010 Notice that is only available this year, together with the anticipated increase in IRS audit activity under Section 409A, it is important for employers to once again review their nonqualified deferred compensation arrangements to determine if correction may be necessary and, if so, take immediate action this year to avoid Section 409A’s punitive tax consequences. White & Case can assist with the identification and correction of documentary, as well as operational, deficiencies under Section 409A.
Correction of Documentary Failures Table
The table on the following pages lists the documentary defects (Columns A and B), summarizes the corrective actions that must be taken prior to the payment event (Column C), describes any available relief (“penalty-free” or “limited”) depending on the amount of time that lapses between the date of correction and the payment event (Columns D and E), and informs whether or not any documentary correction is available after the payment event has occurred (Column F).