The Internal Revenue Service ("IRS") has issued Notice 2008-113 (the "Notice"), which expands the correction program for failures to operate nonqualified deferred compensation plans and arrangements in compliance with Section 409A of the Internal Revenue Code.

Consequences of a Section 409A Violation

Section 409A provides specific rules for the documentation and operation of nonqualified deferred compensation plans, such as the timing of deferral elections and when payments can be made. The service provider (e.g., an employee) will be subject to severe penalties if the requirements of Section 409A are not satisfied. The penalties include (i) immediate taxation of all post-2005 compensation deferred under the plan (and any plans that are required to be aggregated with such plan) to the extent such amounts are vested and not previously taxed, (ii) a 20 percent additional tax on such amount and (iii) in some cases, a premium interest tax on the deemed tax underpayments.

Overview of Correction Program

Given that the slightest failure by a service recipient (e.g, an employer) to satisfy Section 409A can subject an employee to its harsh penalties, the IRS established a limited correction program in 2007 and subsequently expanded the program by issuance of the Notice. The correction program provides either "penalty-free relief" (i.e., no Section 409A penalties are imposed) or "limited relief" (i.e., the amount includible in income under Section 409A and subject to the 20 percent additional tax (but not the premium interest tax) is limited to the erroneous amount involved and does not include any other amounts deferred under the plan). The scope of the relief depends on the following four factors: (i) the type of error, (ii) the status of the affected participant, (iii) the timing of the correction and (iv) the amount involved.

Type of Errors

The relief is limited to four types of operational failures that occur in violation of the terms of the plan, any applicable deferral election, or Section 409A.

  • Early Payment of Amounts Payable in a Subsequent Year. Here, an amount of nonqualified deferred compensation that should have been paid to an employee in a future year was erroneously paid in an earlier year. An employer's failure to defer a sufficient amount under the plan on behalf of an employee (and current payment of the shortfall) falls within this category.

Early Payment of Amount Payable in the Same Taxable Year or Early Payment in Violation of the Six-Month Delay Rule. Here, an amount of nonqualified deferred compensation either (i) was paid to an employee in the same taxable year in which the amount was payable under the plan, but more than 30 days before such date; or (ii) is required to be delayed for six months following a specified employee's separation from service (the "six-month delayed payment rule"), but was paid to such employee within that six-month period.

  • Excess Amount Deferred or Delayed Payment. Either (i) an amount that should not have been deferred compensation under the plan was erroneously credited to the employee's account (or otherwise treated as deferred compensation under the plan) instead of paid to the employee; or (ii) an amount of nonqualified deferred compensation, which should have been paid to an employee during a taxable year, remained deferred after such year.
  • Incorrect Exercise Price of Stock Rights. Here, a stock right (stock option or stock appreciation right) that was otherwise exempt from Section 409A, becomes subject to the rules of Section 409A (and penalties in the event of noncompliance) solely because the exercise price of the stock right was erroneously established at less than the fair market value of the underlying stock on the date of grant.

Participant Status

The correction program provides less leniency if the affected employee is an "insider" (a director, officer or greater-than-ten percent owner of such employer). Unlike other participants, insiders (i) generally must repay any early receipt of deferred compensation with interest; (ii) are ineligible for a 24-month grace period to return the amounts erroneously received if such repayment would cause an "immediate and heavy financial need"; (iii) are only eligible for penalty-free relief if the error is corrected by the end of the year in which that error occurs and (iv) must adjust account balances for earnings on excess deferrals (or late payments) retroactive to the date an amount was incorrectly credited to the account (or incorrectly maintained in the account as a deferral).

Timing of Correction

Penalty-free relief is provided if certain errors are corrected in the same taxable year (or by the end of the year immediately following the year of the error in the case of non-insiders); whereas limited relief is available if certain errors are corrected thereafter, within the confines of the Notice.

Amount Involved

If the amount involved does not exceed the Section 402(g)(1)(B) deferral limit in effect for the year of the error (US$16,500 for 2009), then limited relief is available. In the case of an early payment, the employee is not required to repay such "small amount." In the case of an excess deferral or late payment, the employer is required to distribute such amount to the employee by the end of the second taxable year following the year of the error.

Correction Procedures

The taxpayer must first determine which, if any, combination of the four factors applies.

Example of a combination

An early payment of an amount payable in a subsequent year (type of error) to an insider (participant status) that is corrected in the taxable year immediately following the year in which such error occurred (timing of the correction) with such erroneous amount being in excess of the Section 402(g) limit in effect for the year of the error (amount involved).

For each scenario, the Notice provides the corrective procedures, reporting and withholding obligations and account adjustments necessary to obtain penalty-free or limited relief with respect to Section 409A violations.

  • Correction procedures. In the case of an early payment, the correction procedures generally involve the employee's repayment (or reduction of the employee's future compensation) by the end of the second year following the year of the error. Repayment with interest at a rate not less than the short-term applicable federal rate from the date of the erroneous payment is required, except in the following cases: (i) a same-year correction by a non-insider (unless the 24-month grace period is utilized); (ii) a same-year correction involving a "small amount" by an insider; or (iii) a 20 percent penalty on the erroneous amount is already incurred by a non-insider who only receives limited relief. Where an excess amount is deferred or a payment delayed, a distribution to the Participant is required. In the case of a stock right granted with an incorrect exercise price, a repricing is required, provided that the stock right has not been exercised.
  • Reporting. The income inclusion and Code "Z" reporting of an early payment on Form W-2 (or Form 1099) is waived if penalty-free relief is received as a result of a same-year correction. Similarly, the income inclusion and Code "Z" reporting of an underpriced stock right is also waived if a same-year correction (or an immediately-following-year correction with respect to non-insiders) of the exercise price is made, provided such stock right has not been exercised. Both income inclusion and Code "Z" reporting are required if limited relief applies. However, only income inclusion (but not Code "Z") reporting is required for the year in which an early payment is made if a non-insider receives penalty-free relief through a correction made in the taxable year immediately following the year the error occurred. Notably, the employee is permitted to take a deduction for the amount of the repayment (excluding any interest payment).
  • Additional information reporting. The employer must notify the IRS of its use of the correction program by attaching to its original federal income tax return a statement that identifies the plan, names the affected employees (and identifies any as insiders), briefly describes the error (including the date and amount involved), states the corrective actions and dates such steps were taken and represents that it has taken the required actions for such correction. A similar statement must be furnished by the employer to each affected employee by the due date for providing a Form W-2 (or Form 1099). The employee must attach the notice to his or her federal income tax return for the year in which such failure was discovered.
  • Withholding. The correction program's withholding procedures are only applicable in the case of an early payment. In the case of a same-year correction of an early payment, if employment taxes were withheld at the time of such early payment, the employer should adjust the employment taxes in accordance with Section 6413 of the Code (or, if repayment is accomplished by reducing an employee's future compensation, then the employment taxes withheld and paid with respect to the early payment may be applied to satisfy the employment tax requirements on the future compensation that is used as an offset).
  • Account adjustments. For "early payments of amounts payable in a subsequent year," the deferred accounts may be adjusted for earnings or losses retroactively during the period the employee was in receipt of an early payment. In the case of an "early payment of an amount payable in the same taxable year" or a violation of the "six-month delayed payment rule," the deferred accounts cannot be adjusted for earnings (but may be adjusted for losses). For excess deferrals (or late payments), the account balance must be adjusted for earnings (but may be adjusted for losses) retroactive to the date the excess amount was incorrectly credited to the employee's account or otherwise treated as deferred under the plan. As an exception, however, the accounts of non-insiders may be adjusted for earnings or losses if the correction is made in the same year as the occurrence of the error.

Other Requirements to Obtain Relief

A taxpayer is eligible for penalty-free or limited relief under the correction program if the applicable correction procedures are met and all of the applicable conditions below are satisfied:

  • the failure is not intentional;
  • the employee is not under examination for the year in which the error occurred (a same-year correction is, however, permissible);
  • the failure does not involve an erroneous payment from the plan during a year the employer experienced a substantial downturn or other financial issues that indicate a significant risk in the employer's ability to pay the amount deferred when the payment becomes due;
  • for years after 2009, the same or substantially similar failure has not occurred previously (unless the employer can demonstrate that reasonable steps were taken to prevent a recurrence of such error); and
  • a documentary error is not being corrected (although the IRS has sought comments on a documentary compliance program).


  • Penalty-free relief is not available under the correction program for a late payment that is corrected in the year immediately following the year of the failure. However, taxpayers may have a narrow opportunity to make the distribution free of any Section 409A penalties, provided that the payment is made by the 15th day of the third calendar month following the payment date specified under the plan.
  • If the amount involved is less than the Section 402(g)(1)(B) limit, the employee is not required to repay an early payment. An employee who is unable (or perhaps unwilling) to repay may choose between limited relief with no repayment and penalty-free relief with repayment.
  • "Insiders" and "specified employees" may overlap, but are mutually exclusive. Only a public company can have specified employees; whereas, insiders exist within all entities, both public and private. Specified employees are generally the top 50 officers; whereas, insiders are all officers as well as directors. Specified employees include five percent owners of an employer; whereas ten percent is the ownership threshold for an insider. The individuals identified as specified employees for a 12-month period is a closed list; whereas an individual may become an insider at any time during a year.
  • In the case of an employee's repayment of an "early payment of an amount payable in the same taxable year" or a "payment in violation of the six-month delayed payment rule," such employee is entitled to receive the deferred compensation on a "postponed date," which is the date that is the later of (i) the originally scheduled payment date or (ii) the repayment date plus the same number of days that the employee was in receipt of the erroneous payment.
  • The correction program provides transitional relief to non-insiders for certain failures that occurred prior to 2008. Accordingly, penalty-free relief is available for a correction in 2009.


Employees, who are in the best position to immediately discover an error in their pay, should immediately raise any compliance issues with their employer to take advantage of the same-year correction program. In addition, the employer should establish various internal controls among its human resources, payroll, legal, technology and other functions, as well as third-party administrators to prevent and promptly detect operational failures.