On December 3, 2007, the US Department of the Treasury and Internal Revenue Service (the “IRS”) issued Notice 2007-100, which announces a program allowing taxpayers to correct certain unintentional operational failures under Section 409A of the Internal Revenue Code. Specifically, Notice 2007-100 provides taxpayers with methods to correct, or limit the amount included in income due to, certain unintentional operational failures under Section 409A, provided that such failures (i) are corrected in the same taxable year in which the failure occurs or (ii) involve only de minimis amounts and occur prior to the end of 2010.
The voluntary correction program is the result of a cooperative process involving Treasury and IRS personnel and representatives from the private sector. White & Case personnel participated in a key request from the American Bar Association and follow-up conferences with Treasury and the IRS, that ultimately led to the issuance of Notice 2007-100. The terms of the correction program set forth in Notice 2007-100 are summarized below.
Enacted as part of the American Jobs Creation Act of 2004, Section 409A is generally applicable to amounts deferred in taxable years beginning after December 31, 2004. Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan are included in income when deferred (or, if later when the amounts are no longer subject to a substantial risk of forfeiture), unless certain requirements established by Section 409A are satisfied. If an amount of deferred compensation is required to be included in income under Section 409A, that amount is subject to ordinary income taxation plus an additional 20 percent income tax and interest may be assessed on tax underpayments in certain circumstances. For more on Section 409A, please click here (and for a more extensive overview of the final 409A regulations, please see An Analysis of the Final 409A Regulations on Deferred Compensation).
Eligibility for Relief. Failures under Section 409A must meet certain preliminary requirements in order to be eligible for relief under Notice 2007-100. First, the failure must be an unintentional operational failure, which is an unintentional failure under plan provisions that satisfy the requirements of Section 409A, or an unintentional failure to follow the requirements of Section 409A in practice, due to one or more inadvertent errors in the operation of the plan. The failure must be non-egregious and unrelated to a tax avoidance scheme. In addition, the employer (or service recipient) must take commercially reasonable steps to avoid a recurrence of the failure.
The relief is not available after 2008 with respect to any failure, or substantially similar failure, that had occurred previously, unless the employer (or service recipient) can demonstrate that (i) it established practices and procedures reasonably designed to ensure that such failure would not recur, (ii) it took commercially reasonable steps to avoid a recurrence of such failure and (iii) such failure occurred despite the employer’s (or service recipient’s) diligent efforts. Relief is also not available in certain cases where the failure occurs during a year in which the employer (or service recipient) experiences a substantial financial downturn. Certain other conditions, such as the timely filing of information with the IRS, may also affect the availability of the relief.
Failures Eligible for Correction in the Same Taxable Year. A taxpayer will incur no penalty under Section 409A with respect to unintentional operational failures under Section 409A that are corrected by an employer (or service recipient) in accordance with Notice 2007-100 within the employer’s (or service recipient’s) same taxable year. Specifically, the following failures, if otherwise eligible for relief, may be corrected, without penalty to the taxpayer, if corrected within same taxable year:
(1) Payment of amounts that should have been deferred (or continued to be deferred);
(2) Deferral (or continued deferral) of amounts that should have been paid;
(3) Payment of amounts to specified employees in violation of Section 409A(a)(2)(B)(i) (i.e., the requirement to delay for six months payments to a specified employee upon separation from service); and
(4) Grant of a stock right (i.e., an option or stock appreciation right) with an exercise price below the fair market value of the underlying stock on the grant date (provided that such stock right would otherwise have been excluded from the application of Section 409A and that such correction is made in the same taxable year and prior to exercise of the stock right). Notice 2007-100 provides specific methods for correcting each type of failure, including special correction requirements for company insiders (i.e., directors, officers or 10 percent stockholders).
Other Failures Eligible for Relief. If not corrected in the same year, the operational failures described in the preceding paragraph (with certain exceptions in the case of below-market stock rights) may be corrected in accordance with Notice 2007-100 in later years, while still affording affected taxpayers limited relief from the penalties of Section 409A. If such a failure occurs prior to the end of 2010 and involves amounts that do not exceed the Section 402(g)(1)(B) limit for the taxable year in which the failure occurs (US$15,500, for 2008), the failure may be corrected by the employer (or service recipient) not later than the end of the employer’s (or service recipient’s) second taxable year following the taxable year in which the failure occurs. In the event of such a correction, the amount includible in income under Section 409A as a result of such failure is limited to the amount incorrectly paid or deferred, as applicable, and does not include any other amounts deferred under the plan.1 In addition, with respect to such amount includible in income under Section 409A, the taxpayer will be required to pay the additional 20 percent income tax but is not required to pay the additional penalty interest provided for by Section 409A.
Expanded Correction Program. Notice 2007-100 outlines and requests comments on a potential expanded correction program under Section 409A. The expanded correction program would be similar to the program set forth in Notice 2007-100 but potentially would offer relief for failures occurring after 2010 or involving more significant amounts.
Notice 2007-100 provides temporary and limited relief from the penalties of Section 409A, but it is a significant first step toward developing a comprehensive Section 409A correction program. Notably, Notice 2007-100 does not provide an avenue for the correction of documentary failures under Section 409A. Accordingly, as described in prior issues of the White & Case Compensation, Benefits and Employment Law Focus, employers and other service recipients maintaining nonqualified deferred compensation plans that are subject to Section 409A should (i) operate such plans in compliance with Section 409A at all times, (ii) bring such plans into full documentary compliance with Section 409A, as soon as possible, but in no event later than December 31, 2008. In addition, employers and other service recipients should identify any operational failures under Section 409A occurring after January 1, 2005 (i.e., the effective date of Section 409A) that can be corrected, or addressed, under the program set forth in Notice 2007-100.