EMPLOYEE BENEFITS UPDATE: 409A CORRECTIONS: IT S THE LAST SIGNIFICANT BITE OF THE APPLE

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1 Executive Compensation November 2010 EMPLOYEE BENEFITS UPDATE: 409A CORRECTIONS: IT S THE LAST SIGNIFICANT BITE OF THE APPLE In this Issue: Operational Failures Are Still Governed By IRS Notice Can Your Company Make Corrections Through Notice ? 2 What You Should Do Now 409A Corrections Table 3 L ike everyone else, you likely are overwhelmed with information about Code Section 409A. Yet revisiting executive compensation arrangements for Code Section 409A before the end of the year and identifying any potential documentation errors will allow you to avoid some significant IRS penalties. WHY YOU SHOULD CARE Code Section 409A violations come with a stiff 20 percent penalty tax on the plan participant. IRS Notice provides companies with either relief or a modified penalty for timely catching and voluntarily fixing documentation errors. The largest benefit to you in revisiting Code Section 409A during 2010 is that if you identify 2009 Polsinelli Shughart PC KANSAS CITY ST. LOUIS CHICAGO DENVER PHOENIX WASHINGTON DC NEW YORK WILMINGTON DE OVERLAND PARK ST. JOSEPH SPRINGFIELD TOPEKA EDWARDSVILLE

2 one of the enumerated documentation errors listed in Notice , you get a final free bite of the apple (no penalties) if you fix the error by December 31, Document failures corrected by December 31, 2010 will be deemed to have been in place on January 1, 2009, which was the original deadline for Code Section 409A corrections. Corrections made after December 31, 2010 will not receive this treatment, and may result in financial consequences to your employees and delays in payments under your plans. As such, because of the potential financial benefit to your employees in correcting document failures prior to December 31, 2010, wouldn t it be better for the company to catch the error today rather than on January 2, 2011? Operational Failures are Still Governed by IRS Notice Keep in mind that Notice is only for correction of documentation errors in nonqualified deferred compensation plans. These errors and their correction methods are summarized below. However, IRS Notice is still the authority on sanctioned methodologies for correcting operational failures under a nonqualified deferred compensation plan. Operational failures arise when a company operates or administers a nonqualified plan in a manner which is not identified or permitted under the terms of the nonqualified plan document. In such instances, Notice is still the governing guidance. Can Your Company Make Corrections Through Notice ? In order to utilize the Notice correction procedures: Plan documentation errors must be inadvertent and unintentional The company must identify all other nonqualified deferred compensation plans with substantially similar document failures and correct such failures The company cannot use the relief for a particular nonqualified plan if an employee participating in that plan is being audited for the year of the correction or the company is being audited for that plan The company must understand that relief is conditioned upon the employee including the tax penalty (if any) on his/her tax return and the company complying with all disclosure and reporting requirements (identify the affected participants, the affected plan, the amount of the error and a description of the error and eligibility for relief) Linked plans and stock rights are generally not eligible for relief Page 2 of 8

3 What You Need To Do Now Instead of viewing this as a scare tactic, view it as an opportunity. Companies need to keep in mind that the IRS has commenced Code Section 409A audits and companies cannot take advantage of the relief available under Notice once an audit has commenced on its nonqualified deferred compensation plan. Notice clearly provides a valuable opportunity for companies to avoid severe penalties and undesirable tax consequences for their plan participants by addressing any documentation problems now rather than later. The table below is a comprehensive tool for identifying whether a particular nonqualified deferred compensation plan has a provision which may be corrected through the use of Notice Any such provisions should be analyzed further with legal counsel. 409A Corrections Table Correction Issue Method of Correction (the Fix ) Applicable Time Period Permissible payment event required payment as soon as reasonably practicable following the payment event. No correction required if payment is made by the later of the end of the year the employee s taxable year in which the permissible payment event occurs or the 15 th day of the third calendar month following the payment event. NOTE: If these provisions are not hardwired into the plan, it is that much easier to miss them inadvertently. Not applicable. The plan designates a payment event, but does not define the payment event or has an ambiguous definition of the payment event (e.g., termination of employment or acquisition ). Amend the plan to correct the provision by either adding language requiring the plan be interpreted as necessary to comply with Code Section 409A, or setting forth explicit definitions of the payment events that comply with the requirements of Code Section 409A. Undefined or ambiguous payment events will not cause the plan to fail to satisfy Code Section 409A if the term is not interpreted to provide for payments that are not allowed under Code Section 409A. Plan may be amended any time to correct the documentation problem, but may not expand the definition to add new payment events or narrow the definition to eliminate existing payment events. Page 3 of 8

4 Correction Issue Method of Correction (the Fix ) Applicable Time Period Plan provision provides for a payment upon an event involving a change in the relationship between the employee and the company that does not qualify as a separation from service under Code Section 409A. Plan provision includes event that would not qualify as a change in control under Code Section 409A. Plan provision includes event that would not qualify as a disability under Code Section 409A. Plan provides payments following a permissible payment event, but designates that the period in which payment may be made is later than 90 days and earlier than 366 days following such payment event. Amend the plan before the impermissible payment event under the plan. Amend the plan to provide for a Code Section 409A change in control event. Plan may be corrected by amending the plan to remove the payment event or include a conforming definition. Amend the plan to correct the provision by removing the period, or setting a period that is 90 days or less and preventing the participant from designating the tax-year of payment. Amendment may not expand or narrow the definition to add or eliminate a payment event. If, within one year following the date of correction, the corrected plan provision is applied to avoid payment that would have been made under the pre-correction plan, 50 percent of the amount deferred must be included in income. impermissible change in control event occurs. Amendment must be effective immediately. If, within one year following the date of correction, the corrected plan provision is applied to avoid payment that would have been made under the pre-correction plan, 25 percent of the amount deferred must be included in income. impermissible disability event occurs. Amendment must be effective immediately. If amendment is made after the impermissible disability event occurs, any payment made under the plan due to the event will be treated as an operational failure and is corrected under Notice occurrence of a payment event. However, if amendment is made after the payment event, but within a reasonable time thereafter, there will not be a Code Section 409A violation so long as the payment event complies with Code Section 409A and the employee includes 50 percent of the amount deferred to which the payment provisions apply as Code Section 409A income. Plan provides for payment upon a permissible payment event, but conditions the payment on an employment-related action of the employee (such as the execution and submission or a noncompete agreement, nonsolicitation agreement or release and waiver). Amend the plan to remove the employer s ability to base the timing of the payment on an employment-related event. If the payment is to made within a designated period, the amendment must provide for payment only on the last day of the designated period. If no such period is designated, the amendment must provide that payment will be made on a fixed date that is either 60 or 90 days after the payment event. Amendment must be made before the payment event occurs. Page 4 of 8

5 Correction Issue Method of Correction (the Fix ) Applicable Time Period Plan provides payment upon both permissible and impermissible events (not including employer or employee discretion). Plan provides payment only upon impermissible payment events. Plan provides for more than one time or form of payment following the occurrence of a single payment event. Plan provides impermissible discretion to employee or recipient to change the time and form of payment. Amend the plan to remove the impermissible payment event(s). Amend the plan to eliminate the impermissible payment event and replace with payment upon the later of separation from service or the sixth anniversary of the date of the correction. If the multiple forms of payment relate to payment following an involuntary AND voluntary separation from service, then amend the plan to provide the same form of payment for both voluntary and involuntary separation from service. If a different issue causes the failure, must eliminate the time and forms of payment until compliant, retaining the time and form of payment resulting in the latest final payment date or the form with the latest commencement date. Amend the plan to remove the discretion to change the time or form of payment. If a default time and form of payment is not set forth in the plan, provide a time and form of payment that will result in the latest final payment date or the form with the latest commencement date. Amendment should be made before employee makes an irrevocable election of an impermissible payment event or before the impermissible payment event occurs. If an employee has elected an impermissible payment event and any of the impermissible payment events would have required payment within one year of the correction, the employee must include 50 percent of the amount payable pursuant to such event as Code Section 409A income. Amendment should be made before impermissible payment event occurs. Employee must include 50 percent of the amount payable pursuant to such impermissible payment event as Code Section 409A income in the year of the correction. payment event occurs and must be effective immediately. If a payment event corrected under this provision occurs within one year of correction, Employee must include 50 percent of the affected amount in Code Section 409A income. payment event occurs and must be effective immediately. If a payment event corrected under this provision occurs within one year of correction, Employee must include 50 percent of the affected amount in Code Section 409A income. Employer has discretion to accelerate payments even though no payment event has occurred (such as the discretion to terminate the plan and make immediate payments). Amend the plan to remove the discretion to change the time or form of payment. If a default time and form of payment is not set forth in the plan, provide a time and form of payment that will result in the latest final payment date or the form with the latest commencement date. earlier of the date the employer exercises its discretion to accelerate a payment and such discretion is irrevocable, or the date a payment has been made under the plan pursuant to the exercise of discretion. Page 5 of 8

6 Correction Issue Method of Correction (the Fix ) Applicable Time Period Plan contains a provision for improper reimbursement or in-kind benefits that does not comply with Code Section 409A (e.g., taxable reimbursement in one year can affect reimbursement amount in another year). Amend the plan to provide for reimbursements or in-kind benefits that comply with Code Section 409A. payment event occurs and must be effective immediately. If a payment corrected under this provision occurs within one year of correction, Employee must include 50 percent of the affected amount in Code Section 409A income. Plan fails to provide for six-month delay of payment for a specific employee. Amend the plan to provide for six-month delay, and provide that payment will be paid no earlier than the later of 18 months following the correction or 6 months following the payment event. payment event occurs. If employee has a separation from service within one year following correction, he or she must include 50 percent of the affected amount in Code Section 409A income. Plan contains a provision for an initial election to defer compensation that does not comply with Code Section 409A (this does not apply to provisions that are eligible for correction of impermissible employer or employee discretion). Amend the plan to remove the ability to make the impermissible initial deferral election and revoke any elections made in reliance on the impermissible provision within the applicable time period and correct any impermissible deferrals under Notice If the impermissible provision has not been relied upon, no amount needs to be included in income. For example, no election has been made or if any election is revoked before the applicable deadline under Code Section 409A. Correction must be made no later than the end of the employee s second taxable year immediately following the taxable year during which the applicable Code Section 409A deadline for making an election occurs. FOR MORE INFORMATION If you have questions or would like more information on this topic, please contact: Mary K. Samsa msamsa@polsinelli.com Courtney M. Brunsfeld cbrunsfeld@polsinelli.com Page 6 of 8

7 Polsinelli Shughart s and Executive Compensation Group Brian M. Johnston, Chair Kansas City bjohnston@polsinelli.com Courtney M. Brunsfeld St. Louis cbrunsfeld@polsinelli.com Michael V. Conger Kansas City mconger@polsinelli.com Hannah R. DeLuca Kansas City hdeluca@polsinelli.com Jamie Zveitel Kwiatek, St. Louis jkwiatek@polsinelli.com Mary K. Samsa Chicago msamsa@polsinelli.com Randal L. Schultz Kansas City rschultz@polsinelli.com William P. Sweeney Chicago wsweeney@polsinelli.com Polsinelli Shughart PC has a deep bench of qualified Employee Benefits attorneys who cover all aspects of plan creation and design, plan compliance and executive compensation agreements. Collectively our attorneys have more than 100 years of combined employee benefits expertise, providing practical, proactive advice, while also striving to develop innovative solutions to all of your employee benefit needs. In this increasingly complex area of compliance responsibility, with a multitude of different legal requirements under the Internal Revenue Code, the Employee Retirement Income Security Act, among other state and federal mandates, the team will work with you to not only minimized the risk of problems, but to develop a strategy for success. A key to such success lies in the development of initial advisory alerts, training programs, educational campaigns and regular internal memorandums that properly outline the compliance obligations as well as the keys of the organization s successful usage of such arrangements. Polsinelli Shughart employee benefit and executive compensation attorneys practice in the following areas: Retirement plans Welfare benefit plans ERISA fiduciary duty and plan investment counseling Employee stock ownership plans ERISA and employee benefit plan litigation Executive compensation To learn more about our services, visit us online at Page 7 of 8

8 If you know of anyone who you believe would like to receive our updates, or if you would like to be removed from our e-distribution list, please contact Therese O Shea via at toshea@polsinelli.com. Polsinelli Shughart PC provides this for informational purposes only. The material provided herein is general and is not intended to be legal advice. Nothing herein should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship. Polsinelli Shughart is very proud of the results we obtain for our clients, but you should know that past results do not guarantee future results; that every case is different and must be judged on its own merits; and that the choice of a lawyer is an important decision and should not be based solely upon advertisements. Polsinelli Shughart is a registered trademark of Polsinelli Shughart PC. About Polsinelli Shughart PC With more than 500 attorneys, Polsinelli Shughart PC is a national law firm that is a recognized leader in the areas of business law, financial services, real estate and business litigation. Serving corporate, institutional and individual clients, Polsinelli Shughart is redefining the business of law by sharing ideas, goals and outcomes with its clients. The firm builds enduring relationships by creating value beyond legal services with passion, ingenuity and a sense of urgency. The firm has offices located in Kansas City; St. Louis; Phoenix; Chicago; Denver; Washington, D.C.; New York; Wilmington; Overland Park; St. Joseph; Springfield; Jefferson City; Topeka and Edwardsville. The firm can be found at Page 8 of 8