Treasury and IRS Issue Guidance under Section 409A on Correcting Document Failures

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1 Executive Compensation & Employee Benefits January 14, 2010 Treasury and IRS Issue Guidance under Section 409A on Correcting Document Failures This client memorandum describes recent guidance from the Treasury Department and the Internal Revenue Service on correcting deferred compensation plan documents that do not meet the requirements of 409A of the Internal Revenue Code. Significantly, the IRS is effectively waiving most of the substantial tax penalties associated with document failures that are corrected by the end of It is important for lawyers and HR and executive compensation professionals to understand the scope of the relief and to begin now to make any necessary corrections. Introduction One of the most significant recent developments affecting compensatory arrangements was the addition in 2004 of 409A to the Internal Revenue Code. The adoption of 409A was motivated in large part by a Congressional desire to address situations like the Enron collapse, where the company had allowed certain senior executives to withdraw money from their deferred compensation accounts shortly before filing for Chapter 11 bankruptcy protection. But 409A applies to far more than cases of corporate collapse. It has resulted in a sweeping overhaul of virtually all deferred compensation. Section 409A generally provides that 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, unless the deferred compensation arrangement meets the document and operational requirements of 409A. Further, amounts includible in income under 409A are subject not only to regular income tax but also to two supplemental taxes: a 20% additional tax on the amount includible in income, and an underpayment interest tax (determined using a premium interest rate). These adverse tax consequences are not limited to senior executives but may fall upon all service providers employees, directors and independent contractors who participate in nonqualified deferred compensation arrangements. The IRS issued complex final regulations under 409A on April 17, 2007, effective for tax years beginning on or after January 1, Treasury and the IRS subsequently provided guidance, in the form of proposed regulations, on the calculation of amounts includible in income under 409A(a) and the additional taxes imposed thereunder. 2 In Notice , the IRS established procedures enabling taxpayers to obtain relief from the full application of the income inclusion and the additional taxes under 409A for certain operational failures under a nonqualified deferred compensation plan. With the recent release of Notice , Treasury and the IRS have created opportunities for correcting many types of failures to comply with the document requirements applicable under 409A to nonqualified deferred compensation plans. The guidance clarifies that certain language commonly included in plan documents will not cause a document NYDOCS01/

2 2 failure and provides relief allowing correction of certain document failures without or with only limited current income inclusion or additional taxes under 409A. Additionally, transition relief is available for certain document failures without current income inclusion or additional taxes under 409A. Plan sponsors and compensation professionals will welcome the relief made available by Notice The Notice, however, does not provide a roadmap for correcting all 409A issues. In particular, the Notice provides only modest additional guidance on how to interpret the complex and occasionally ambiguous provisions of the final regulations under 409A. Plan sponsors will continue to face significant challenges in determining whether they have a document failure. Nevertheless, for situations where a document failure can be unambiguously identified and falls within one of the categories of failure eligible for correction, utilization of Notice is likely to prove a valuable strategy for minimizing 409A pain. Notice complements the earlier guidance set forth in Notice on operational failures and, as will be developed below, in many respects operates in tandem with it. General Framework Notice adopts a structural framework that is similar to that applicable to the correction of operational failures under Notice In order to qualify for relief under Notice , all of the following conditions must be satisfied: The taxpayer must demonstrate that certain general eligibility conditions have been satisfied. We review these below and compare them to the similar, but not identical, general eligibility conditions that apply to correction of operational failures under Notice Specific corrective actions, including plan amendments, must be taken by the deadline specified in the Notice for the particular type of document failure. Both the service recipient (generally, the employer) and the service provider (generally, an employee, director or independent contractor) must comply with specified information and reporting requirements. Depending on the nature of the document failure and, in the case of certain failures, on events that occur within one year following the date of correction, 3 Notice provides one of several forms of relief: For certain types of document failure, timely correction effectively fixes the problem once and for all. As long as the correction is made by the deadline specified for the particular document failure, the service recipient will not be required to report, and the service provider will not be required to recognize, income under 409A based solely on the pre-correction plan defect. For a broad range of other types of document failure, timely correction of the plan defect will exempt the service recipient and service provider from the harsh consequences of 409A, but only if certain events have not occurred before the date of correction and do not occur during the year following the date of correction. The events that will disrupt this favorable treatment fall, broadly, into two categories: those that would have triggered payment of a deferred amount under the pre-corrected plan (but not under the corrected plan); and conversely, those that would trigger payment under the corrected plan (but not under the pre-corrected plan). Where one of these triggering events occurs within the first year following the date of correction, the service recipient is required to recognize a specified amount of 409A income typically 50% of the amount deferred under the plan, determined as of the last day of the service provider s taxable year in

3 3 which the event occurs. The amount recognized in income will be subject to federal income tax at the normal rates applicable to the taxpayer plus the 20% additional tax imposed under 409A, but will not be subject to 409A s premium interest tax. In a more limited range of circumstances, an amount is required to be included in income under 409A as a condition of a document correction without regard to whether a subsequent event occurs. In these situations, the amount deferred under the plan is determined as of the last day of the service provider s taxable year during which the correction is made. from any explicit limitation in Notice but from the interplay between Notice and Notice A service recipient s insiders for this purpose are its officers or directors as determined in accordance with the rules under 16 of the Securities Exchange Act of 1934, whether or not the service recipient has securities registered under that Act. 4 For service recipients that are not corporations, the 16 rules are applied by analogy. In all cases, if a document failure is fully corrected in accordance with Notice , the service provider will not be required to include income under 409A for any year before the year of correction solely as a result of the document failure. Finally, for certain other types of document failure, timely correction will not result in income recognition under 409A, but relief under Notice is conditioned on correcting any operational failures that occurred as a result of the pre-correction plan terms in accordance with Notice The relief available for a service recipient s insiders is frequently more limited than that available to other service providers. This disparate treatment results not General Eligibility Requirements A taxpayer must meet certain eligibility requirements to be eligible for relief under Notice for a document failure. The taxpayer claiming the relief has the burden of demonstrating eligibility for the relief. The following table summarizes the general eligibility requirements under Notice and presents the comparable requirements under Notice Type of requirement Commercially reasonable steps Not under examination by the IRS Reporting requirements Notice (document failures) The service recipient ( SR ) must take commercially reasonable steps to identify and correct all other nonqualified deferred compensation plans that have a substantially similar document failure.5 Relief is not available for a service provider ( SP ) if the federal income tax return of the SP or the SR is under examination with respect to nonqualified deferred compensation for any taxable year in which the document failure existed. Special transition relief, discussed below, is available for examinations of SRs (but not of SPs) commenced before the end of Relief is conditioned on timely reporting of information required by the Notice, including a requirement that the SP include in income any amount required to be included under the Notice and pay all applicable federal taxes, including the additional 20% tax under 409A. Notice (operational failures) SR must take commercially reasonable steps to avoid a recurrence of the operational failure. Relief is not available if SP s federal tax return for the year in which the operational failure occurred is under examination with respect to the plan. Relief is conditioned on timely reporting of information required by the Notice.

4 4 Type of requirement Inadvertent and unintentional failures Repayment of gross amount Notice (document failures) Relief is available only for document failures that are inadvertent and unintentional. No equivalent. Notice (operational failures) Relief is available only for operational failures that are inadvertent and unintentional. Where relief is conditioned on SP s repayment to the SR of an amount erroneously paid or made available, the amount to be repaid is the gross amount before withholding. No financial downturn No equivalent. Relief is not available with respect to any erroneous payment occurring during any taxable year of the SP in which the SR experiences a substantial financial downturn. General Eligibility Requirements Service Providers and Service Recipients Under Examination Relief under Notice is not available if, as of the date the plan is corrected, the IRS is examining a federal income tax return of the service provider or the service recipient with respect to nonqualified deferred compensation for any taxable year in which the document failure existed. The standard for when a federal return is considered to be under examination with respect to deferred compensation differs depending on whether the service provider or service recipient is an individual: For an individual service provider which will cover virtually all employees or service recipient, a federal income tax return is treated as under examination with respect to nonqualified deferred compensation if the individual is under examination with respect to the individual s federal income tax return for the relevant year. Apparently, the examination may relate to any matter on the return. For non-individual service providers and service recipients such as employer corporations a federal income tax return is considered under examination if the service provider or service recipient receives written notification from the examining agent(s) specifically citing nonqualified deferred compensation as an issue under consideration. made by December 31, 2011, a non-individual service recipient that is under examination for periods beginning on or before December 31, 2011 will be treated as under examination only with respect to specific document failures that have been identified as an issue in the examination. Requiring that neither the service provider nor the service recipient be under examination may lead to some harsh results, particularly given that control of the timing of the correction of document failures will typically rest with the service recipient the employer. The following example provides an illustration.... Facts: Company A maintains two nonqualified deferred compensation plans with payment formulas that are linked in a manner that is not permitted under 409A. Company A becomes aware of the defect in January 2011 but, in reliance on the transition relief of Notice (discussed below), does not adopt correcting amendments until November 30, On July 1, 2011, Employee X, who is a participant in the Company A plans in question, receives notification from the IRS that his 2009 Form 1040 is under examination with respect to certain expenses claimed on Schedule C. Transition relief in Notice mitigates these results for service recipients, but not for service providers. In particular, for document corrections

5 5 Analysis: Because X s Form 1040 for 2009 is under examination (albeit with respect to a matter unrelated to deferred compensation) when A amends the impermissibly linked plans, the relief of Notice is not available to X with respect to As a result, X may be required to recognize income under 409A for General Eligibility Requirements Information and Reporting Requirements Reliance on Notice is conditioned on both the service recipient and service provider satisfying the information and reporting requirements set forth in XII of the Notice. 6 The service recipient is required to attach a statement to its federal tax return for the year the correction is made, as well as for any subsequent year in which the service provider is required to include an amount in income as a condition to relief under the Notice. The service recipient must also provide the service provider with a separate statement that the service provider must attach to its federal tax returns for the year the correction is made and for any subsequent year in which the service provider is required to include an amount in income as a condition to relief. The required statements generally must identify the plan with respect to which the document failure occurred and the section of Notice under which the failure was corrected. They must include, among other information, the date of correction and of any subsequent event requiring the inclusion of income under the terms of the Notice, the amount involved in the document failure and, to the extent applicable, the amount reported by the service provider as part of the correction. It is important for plan sponsors and other interested parties to recognize that these information and reporting requirements apply even to those types of failure whose correction does not require employees or other service providers to recognize income under 409A. If nothing else, the requirements will call to the attention of the IRS that there has been a mistake and an effort to fix it. Transition Relief Notice includes transition relief that will afford plan sponsors the opportunity to correct document failures during 2010 and to spare their employees the income recognition that might otherwise apply. 7 As already noted, in certain situations Notice requires service providers to recognize income under 409A if triggering events occur within one year following the date that a document failure is corrected. Under transition relief, however, income recognition will not be required regardless of whether the specified triggering event occurs within one year following the date of correction as long as two conditions are satisfied: The document failure is corrected in accordance with Notice by December 31, 2010; and Any payment made before December 31, 2010 that would not have been made under the corrected plan (or, any failure to make a payment before December 31, 2010 that would have been made under the corrected plan) is treated as an operational failure under Notice and is corrected by December 31, In many situations, only the first of these conditions should apply, as there will be no operational failure to correct.... Facts: Company B sponsors a nonqualified deferred compensation plan for the benefit of its employees that provides for the distribution of deferred amounts upon a change in control of B. The definition of change in control does not comply with the requirements of 409A. Company B amends the definition to comply with 409A on December 1, No change in control under the pre-correction definition occurs before the date of correction. Analysis: There is no operational failure that requires correction. Transition relief is available under Notice because the document failure was corrected by December 31, Employees who

6 6 participate in Company B s plan will not be required to recognize income under 409A even if, within one year of the date of correction, an event occurs that would have constituted a change in control, and thereby triggered payment, under the pre-correction plan but does not constitute a change in control under the amended plan.... Even where there are operational failures, the provisions of Notice should in many circumstances spare service providers the adverse tax consequences of 409A as long as the operational failure is corrected by December 31, Facts: Same as above, except that an event that constituted a change in control under the pre-correction definition (but not under the amended definition) occurred on July 1, 2010, and B distributed account balances to participants in accordance with the terms of the pre-correction plan. In compliance with IV.A of Notice , all employees who received distributions repay the distributed amount (with any interest required by Notice ) to B by December 31, Analysis: Under IV.A of Notice , the payments made by B as a result of the pre-correction change in control are not required to be included in income by the employee participants for 2010 or reported by B as income on Form W-2. In addition, by virtue of the transition relief in Notice , employees will not be required to recognize income under 409A even if, within one year of the date of correction, an event occurs that would have constituted a change in control, and thereby triggered payment, under the pre-correction plan but does not constitute a change in control under the amended plan.... It is important to recognize nevertheless that not all corrections under Notice will result in employees receiving a free pass under 409A. In particular, where operational failures have occurred, their correction may trigger income recognition. This is a risk especially for employees who are considered insiders of the service recipient, by virtue of the more limited circumstances in which operational failures relating to insiders can be corrected under Notice without triggering income recognition. The following example illustrates this point.... Facts: Company C sponsors a nonqualified deferred compensation plan that provides for payment of a service provider s account balance in a lump sum upon separation from service. The definition of separation from service does not comply with the requirements of 409A because it includes transition from employee to independent contractor status without regard to any reduction in the hours of service. On June 30, 2009, employees X and Y transitioned from employee to independent contractor status with a 50% reduction in hours of service per week. X is not an insider of C, while Y is an insider. The transitions of both X and Y were treated as a separation from service under the plan, but would not qualify as a separation from service for purposes of 409A. In accordance with the plan terms, both X and Y received a lump sum payment of their account balances on July 15, On May 31, 2010, C amends the plan to define separation from service in accordance with 409A. Analysis: The inappropriate lump sum payment made to X on July 15, 2009 is eligible for correction under V.B of Notice Essentially, X will be required to repay the amount erroneously paid in 2010, with interest, and the premature payment will be ignored for purposes of 409A. Because Y is an insider of C, Y is not eligible for the same relief under Notice Instead, the operational failure with respect to Y can be corrected under VII.B of Notice Y will be required to repay the severance amount to C with interest, and will be required to recognize that amount as income under 409A for The 20% additional tax

7 7 will apply, but, by virtue of the relief afforded by Notice , not the premium interest tax. Because C corrected the document failure by December 31, 2010, and the relevant operational failures have been corrected pursuant to Notice by December 31, 2010, the provisions of Notice that might otherwise require X and Y to recognize income under 409A if they experience a separation from service with C on or before May 31, 2011 will not apply.... Taking Advantage of Transition Relief: Key Next Steps Most plan sponsors conducted comprehensive reviews of their nonqualified deferred compensation plans before the compliance deadline of January 1, 2009 and implemented changes to conform to the requirements of 409A. To the extent, however, that subsequent guidance or experience calls into question whether existing plans comply in all respects with 409A, the transition relief of Notice offers a valuable window of opportunity for plan sponsors to take a fresh look at their plan documents and make any necessary changes. Notice provides separate transition relief for impermissible provisions linking two or more nonqualified deferred compensation plans and for provisions that would be considered to provide for a fixed schedule of payments but for failure to comply with the requirement to provide objective, nondiscretionary methods to identify both the payment amount and the payment schedule. In both instances, plan sponsors have until December 31, 2011 to make required corrections. Any erroneous payments, or failures to pay, resulting from application of the pre-correction plan terms must be treated as operational failures and corrected under Notice by December 31, Coordination with Notice The interplay between Notice and Notice will require careful consideration based on the precise facts of any particular situation. Both plan sponsors and participants should take comfort from those provisions of Notice that allow document failures to be corrected without income recognition under 409A provided that any related operational failures are corrected in accordance with Notice Many operational failures can, pursuant to Notice , be disregarded for purposes of 409A if they are corrected in the same taxable year or, in the case of service providers who are not insiders, by the end of the following taxable year. The ability to treat certain compliance failures resulting from defective documentation as operational failures under Notice is taxpayer-friendly in another respect. In order to be eligible for relief under Notice or Notice , a failure must be inadvertent and unintentional. While the inclusion of an impermissible provision in a nonqualified deferred compensation plan, or the omission of a provision required under 409A, might well be inadvertent and unintentional, one might have questioned whether a violation of 409A resulting from application of that provision could be so characterized. (For example, it is not self-evident that a payment made as a result of applying a defective definition of separation from service is an unintentional violation.) By allowing these compliance failures to be addressed under Notice , Treasury and the IRS are permitting taxpayers to mitigate the harsh results of failures to comply with 409A. Correcting Document Failures The following chart summarizes, for each type of document failure identified in Notice , the deadline by which the defect can be corrected pursuant to the Notice, the manner in which the provision must be amended, and other principal considerations, including

8 8 the effect of the amendment. Generally, amendments to plan documents must be effective immediately. The chart summarizes the requirements for correcting each type of document failure treated in Notice but does not reflect the waiver of income recognition requirements for corrections eligible for transition relief as discussed above. The chart, moreover, is a summary and does not set forth all details of the requirements of the Notice. Notice does not provide relief for stock rights (stock options and stock appreciation rights). On the other hand, Notice already provides fairly generous relief for stock rights that fail to satisfy the requirements of 409A because they have an exercise price that is less than the fair market value of the underlying shares on the date of grant. 8 Under Notice , to the extent that an option or SAR has not been exercised, the exercise price may be reset to an amount at least equal to the grant date fair market value, without penalty to the service provider, as long as the correction is made by the end of the year in which the grant date occurs (or, in the case of service providers who are not insiders, until the end of the following year). 9 With the exception of the transition relief noted earlier, Notice also does not provide relief for document failures relating to linked plans that is, plans where the amount deferred under one plan, or the time and form of payment under the plan, is determined or affected by the amount deferred or payment terms of another deferred compensation plan. Special rules under Notice apply if two or more document failures relating to the same deferred amount are corrected. These rules, which limit the amount of income that a service provider would be required to recognize under 409A if the provisions of Notice were applied independently to the correction of the multiple failures, are not addressed in the following table.

9 9 Abbreviations used in the following table: IPE = impermissible payment event PPE = permissible payment event SFS = separation from service SP = service provider SR = service recipient TFP = time or form of payment Document Failure Deadline for Correction Required Correction Other Considerations 1. Terms providing for payment as soon as practicable (or using substantially similar general language) following a PPE Correction not required. None. No operational failure as long as payment is made in compliance with the payment timing rules of 409A. 10 But if the SR has a pattern or practice of making late payments that do not meet the payment timing rules, the plan will be treated as having failed to set forth a permissible payment date. Practice Tip: Expressions such as as soon as practicable following a specified payment date raise concerns under 409A, as they arguably do not specify a payment schedule with adequate precision. While Notice reassures taxpayers that the use of these terms will not result in a document failure as long as payment is made in compliance with the payment timing rules, we continue to encourage plan sponsors to use fixed dates and deadlines when specifying payment schedules (for example, provide for payment to be made on a specified payment date or as soon as practicable, but in no event more than 60 days, following a specified payment date). 2. PPE with no definition or ambiguous definition (e.g., termination of employment ) Correction is generally not required as long as the plan is administered so that payments satisfy the requirements of 409A. If an amount is paid in a manner that does not comply with the requirements of 409A, the payment may be treated as an operational failure eligible for relief under Notice provided the plan is amended before the end of the SP s taxable year in which the operational failure is corrected. Where amendment is required, either: add language requiring that the terms of the plan be interpreted to comply with 409A; or define the ambiguous terms consistent with the requirements of 409A. Correction may not expand on or contract the original list of payment events. Practice Tips: This correction method would in many cases effectively allow eligible plans to be corrected, without income inclusion or penalties under 409A, until the end of the year following the year during which an impermissible payment was made. (For insiders of the SR, the plan generally could be corrected until the end of the year during which the impermissible payment was made without triggering 409A income inclusion or penalties.) An amendment to provide definitions of previously undefined or ambiguous terms must use the default definitions specified in the 409A regulations, rather than any permissible alternative

10 10 Document Failure Deadline for Correction Required Correction Other Considerations definitions. For example, separation from service must be defined by reference to a reduction in services to a level equal to 20% or less of historic services, and the SR could not take advantage of discretion otherwise available to specify a percentage greater than 20% but less than 50%. 11 Correction of ambiguous plan terms as described above does not trigger the information and reporting requirements of the Notice. 3. Impermissible definition of separation from service Correction may be made before an event that either: would not be an SFS under 409A but is a payment event under the plan, or is an SFS under 409A but is not a payment event under the plan. Amend to provide for a payment event that satisfies the requirements of 409A. Correction may not expand on or contract the original list of payment events. If within one year following the date of correction, an event occurs that is not an SFS under 409A but would trigger payment under the pre-correction plan (or that is an SFS under 409A but would not have required payment under the pre-correction plan) and that results in the corrected plan provision being applied to avoid (or make) a payment that would have (or would not have) been due under the pre-correction plan, 50% of the amount deferred under the plan to which the pre-correction plan provision would have applied must be included in income by the SP (the 50% Income Inclusion Rule ). Practice Tips: The treatment under Notice of faulty definitions of SFS introduces the concept that some income recognition will be required if, within one year following the date of correction, an event occurs that triggers the application of the corrected definition to achieve a different result than would have applied under the pre-correction plan. It may seem ironic that SPs to companies that attempted to reflect the 409A standard of SFS in their plans, but did so inadequately, may in some instances be treated more harshly than SPs to companies that did not make the attempt and retained an ambiguous payment term such as termination of employment. As in the case of amendments to correct undefined or ambiguous payment terms, the corrected definition of SFS may not utilize any alternative definition of SFS that otherwise would have been permitted. 4. Impermissible definition of change in control event Correction may be made before an event occurs that is a payment event under the plan but is not a change in control event under 409A. Amend plan to provide only for change in control events that satisfy 409A. Correction may not cause an event that was not a payment event under the original terms of the plan to become a payment event under the plan. If within one year following the date of correction, a transaction occurs that is not a change in control event under 409A and that results in the corrected plan provision being applied to avoid a payment that would have been due under the pre-correction plan, 25% of the amount deferred under the plan to which the pre-correction plan provision would

11 11 Document Failure Deadline for Correction Required Correction Other Considerations have applied must be included in income by the SP. Practice Tip: The prohibition on allowing the amended change-in-control definition to introduce new payment events is somewhat ambiguous. Consider a plan that defines a change in control to include the accumulation by any one person of more than 40% of the voting power of the company. This definition does not satisfy the requirements of 409A. But a definition triggered by the accumulation by one person of more than 50% of the company s voting power would be acceptable, as would a definition triggered by the accumulation by one person of more than 30% of the company s voting power during a 12-month period. 12 Could the defective definition be amended to include both standards? Or could it be amended at all to include the 30%/12-month standard (or would such an amendment be considered the addition of a new payment event by virtue of the inclusion of a threshold lower than the 40% threshold in the original definition)? The answers are not evident. 5. Impermissible definition of disability Correction may be made before an event occurs that is not a disability within the meaning of 409A but is a payment event under the plan. Either: remove the payment event; or define the payment event as a disability within the meaning of 409A. Plan may also be corrected after an event occurs that is not a disability within the meaning of 409A but is a payment event under the pre-corrected plan, but only if the entire amount paid under the pre-corrected plan would be eligible for correction under Notice and is treated as an operational failure under that Notice. Practice Tip: A 409A-compliant definition of disability is required only if disability itself, rather than SFS occasioned by disability, is the payment trigger under the plan. Plan sponsors nevertheless should ensure that their plans do not provide for a separate time and form of payment for amounts due upon separation from service for disability in violation of the requirement that only a single payment schedule be designated for any permitted payment trigger. See row 11 below. 6. Payment periods of longer than 90 days (and earlier than 366 days) following a PPE Correction may be made before the occurrence of the PPE to avoid application of the 50% Income Inclusion Rule. Either: remove the period following the PPE during which the payment may be made or commenced; or set forth a period that complies with 409A. If the plan is not amended before the occurrence of the PPE but is amended within a reasonable time thereafter (so that the amount is paid within 90 days following the PPE and the SP does not have the right to designate the year of payment), the 50% Income Inclusion Rule applies. Practice Tip: It is important to correct payment period provisions before a PPE occurs. If the correction is not made before the occurrence of the PPE, the 50% Income Inclusion Rule will apply even if the payment in fact is made within 90 days and the plan document is corrected within a reasonable time after the occurrence of the PPE. During 2010, however, transition relief should help mitigate this unfavorable result. 7. Payment periods following a PPE dependent upon the SP completing certain employment-related actions (i.e., execution of noncompetition agreement, nonsolictation agreement or release of claims) Correction may be made before the occurrence of an event that would be a PPE to which the provision applies. Remove ability of the SP to delay or accelerate the timing of the payment as a result of the SP s actions. If the pre-correction plan provides for a designated payment period following the PPE, the amendment must provide for payment on the last day of the period; if the pre-correction plan does not provide for a designated payment period following the PPE, the A plan that provides for payment within 90 days following SFS conditioned upon the SP s execution of a release in favor of the employer would need to be corrected. A plan that provides for payment on the 90 th day following SFS conditioned upon the SP s having executed a release in favor of the employer by that deadline complies with 409A requirements and does not need to be

12 12 Document Failure Deadline for Correction Required Correction Other Considerations amendment must provide for payment either 60 or 90 days following the occurrence of the PPE. amended. Practice Tips: An encouraging aspect of this relief is that the 50% Income Inclusion Rule is not applicable, even if a PPE occurs within one year following the date of correction. Although Notice may be read to suggest the contrary, it is not evident that conditioning the timing of payment upon the actions of the SP will always run afoul of 409A s requirements. Consider, for example, a plan that provides for a lump sum payment to be made on a date within the 90-day period beginning on January 2 of the year following the year in which an SP experiences an SFS, with payment to be made on the day within the period that the SP delivers a release of employment-related claims to the SR and the release becomes non-revocable. Although the timing of payment within the (permissible) 90-day period is within the control of the SP, the payment arrangement appears to comply with the requirements of Treas. Reg A-3(b), since the 90-day period will necessarily begin and end within the same taxable year of the SP. 8. Inclusion of one or more PPEs and one or more IPEs Two possibilities: Correction may be made before the date an IPE has been irrevocably elected as a payment event by the SP or otherwise applies to the amount deferred by the SP. No adverse consequences to the SP. To the extent one or more IPEs has been irrevocably elected by an SP or otherwise has become applicable to the SP s deferred amount, correction may be made before the date any IPEs occur. 50% Income Inclusion Rule may apply (see Other Considerations). Remove the impermissible payment event. If the amendment is made after the SP has irrevocably elected an IPE or the IPE otherwise has become applicable to the SP s deferred amount, the 50% Income Inclusion Rule will apply if any of the IPEs that would have required payment under the pre-correction plan occurs within one year following the date of correction. Practice Tip: An impermissible payment event may be considered to apply to a deferred amount even if the event has not occurred and has not explicitly been elected by the SP as a payment trigger. Notice uses the example of an employment agreement that entitles the employee to payment of a deferred amount upon the earlier of an SFS (which is a PPE) or an initial public offering of the employer s stock (which is not a PPE). Even if the employment agreement is amended to remove the initial public offering payment trigger, the 50% Income Inclusion Rule will apply if an initial public offering occurs within one year following the date of correction. As in other situations, transition relief will be available to avoid this result as long as the correction is made by December 31, Inclusion only of one or more IPEs (no PPEs) Correction may be made before the date one or more of the IPEs occur. Remove all IPEs. Replace with a provision for payment upon the later of: the SP s SFS; and the 6 th anniversary of the date of correction. 50% Income Inclusion Rule applies. Practice Tip: In view of the extensive review and amendment process undertaken by most sponsors of deferred compensation plans in anticipation of the January 1, 2009 effective date of the final regulations under 409A, there should be few plans in existence that provide for payment of deferred amounts only upon the occurrence of impermissible payment events. (Notice gives the example of a plan that provides for

13 13 Document Failure Deadline for Correction Required Correction Other Considerations payment of a deferred amount upon the SP s child enrolling in an institution providing for post-secondary education.) Notice treats such plans in a punitive manner that will require SPs to recognize income under the 50% Income Inclusion Rule whether or not the IPE ever occurs. The only way to avoid application of the 50% Income Inclusion Rule for participants in this unhappy situation is to rely on transition relief to make the required corrections by December 31, Terms that provide for more than one TFP based on whether an SP s SFS is voluntary or involuntary 11. Terms that provide for multiple TFPs based on other factors Correction may be made before the date an SFS occurs that could result in the impermissible multiple TFPs. Correction may be made before the date that could result in the impermissible multiple forms of payment for the SP. Form of payment upon voluntary SFS will be the same form of payment the pre-correction plan provided for involuntary SFS. Remove forms of payment as follows: of two forms of payment, retain the form resulting (or potentially resulting) in the latest final payment date; if two forms result (or potentially result) in the same latest final payment date, retain the form of payment commencing (or potentially commencing) at the latest possible date; and if commencement dates are the same, retain the form of payment generally anticipated to result in the amount being paid at later dates. (We refer to these principles collectively as the Latest Payment Rule.) If the SP has a voluntary SFS within one year following the date of correction which results in the correct plan provision being applied to avoid a form of payment that would have been due under the pre-correction plan, the 50% Income Inclusion Rule applies. If a payment event corrected under this provision occurs within one year following the date of correction, the 50% Income Inclusion Rule applies. If a form of payment has no possibility of applying to an SP, that form of payment is not required to be removed from the plan with respect to that SP. Practice Tips: In general, a plan may specify only one TFP upon the occurrence of any PPE. 13 An exception exists for SFS, where a plan may designate a TFP for SFS generally, and a distinct TFP for either (or both) of: (i) SFS during a limited period, not to exceed two years, following a change in control event; and (ii) SFS before or after a specified date (including attainment of a specified age) or before or after a combination of a specified date and a specified period of service. A plan is not, however, permitted to designate one TFP for SFS generally but a special TFP upon certain forms of SFS not identified in (i) or (ii), e.g., a separate TFP for SFS due to disability. The special rule for alternative forms of payment that could never apply to a particular SP appears to be an exception to the general requirement in Notice that SRs take commercially reasonable steps to identify and amend all other plans that have a document failure substantially similar to one being corrected in reliance on the Notice. The practical implications of this exception are likely to be modest, at least where the multiple TFPs are set forth in a plan document that applies generally to a participant population. In these situations, the SR is likely to amend the plan in a manner applicable to all participants, whether or not an individual participant would ever have become eligible for a TFP that is being removed. 12. Impermissible discretion to change the TFP of an amount due following a permissible payment event, where the plan: (i) provides a default TFP that Generally, no correction is required if: the SR and/or SP do not exercise their discretion; or None. If any SP to the same SR participates in a plan with a substantially similar provision and either the SR or the SP exercises discretion to change the TFP that is not revoked at least

14 14 Document Failure Deadline for Correction Required Correction Other Considerations applies in the absence of an exercise of discretion; and (ii) does not provide discretion to change the TFP after the payment event has occurred if any exercise of discretion is revoked at least one year before the payment event occurs. (But see Other Considerations.) one year before the payment event occurs, the SR must take commercially reasonable steps to identify and correct all substantially similar provisions in other plans. Practice Tips: This remedial provision, which does not require application of the 50% Income Inclusion Rule, is available only where the plan specifies a default TFP that applies in the absence of SR or SP discretion. Notice gives the example of a plan providing for payment of a deferred amount when the SP attains age 65, with payment to be made in the form of 10 annual installments, unless the SR otherwise determines to pay the amount in a lump sum. Plan sponsors will need to be attentive to the limitations on this relief provision that are based on exercises of discretion with respect to arrangements in which other SPs participate. For example, if the arrangement described in the preceding bullet point applied to six SPs, and the SR exercised its discretion with respect to any one of them and did not revoke its exercise of discretion before the SP s 64 th birthday, then, in order for the relief to be available for the five SPs as to which discretion was not exercised, the SR would have to take commercially reasonable steps to amend the arrangements for all of the SPs by removing the plan provision for discretion. Relief for the one SP with respect to whom the SR exercised discretion would be available under the provision described below in row All other cases of impermissible discretion to change the TFP of an amount due following a permissible payment event Correction may be made before a payment event occurs. If the plan has a default TFP, remove discretion to alter the TFP (with the result that the default rule will apply). If the plan does not include a default TFP, amend the plan using the Latest Payment Rule. If a payment event to which the correction applies occurs within one year following the date of correction (including where an SP or SR had exercised its discretion before the correction and had revoked the discretion within one year of the occurrence of the payment event), the 50% Income Inclusion Rule applies. Practice Tips: The distinction between plans that provide for a default TFP and those that do not is critical to the type of relief available under Notice Notice provides, as an example of a plan without a default provision, one under which payment of a deferred amount will be made when the SP attains age 65, with payment to be made in the form of 10 annual installments or in a lump sum, as determined at the sole discretion of the SR. If the plan is corrected before the SP reaches age 65, relief under Notice will be available, although the SP will be required to recognize income under the 50% Income Inclusion Rule if he reaches age 65 within one year of the date of correction (unless the amendment is made during 2010 and is eligible for transition relief). If, however, the SP has already turned 65 by the time the plan is amended, no relief (including transition relief) under Notice will be available, and the SP will be subject to the full adverse tax consequences of 409A. Application of the Latest Payment Rule may raise uncertainties where a plan fails to specify any payment schedule at all. Consider, for example, a plan that provides for payment of a deferred amount equal to one year of salary upon the SP s separation from service, without indicating how or when the amount will be paid. Payment of the amount as salary continuation rather than, for example, in a lump sum immediately upon SFS can probably be considered consistent with the Latest Payment Rule, but the situation is not explicitly addressed in the Notice.

15 15 Document Failure Deadline for Correction Required Correction Other Considerations 14. Impermissible SR discretion to accelerate payment events Correction may be made before the earlier of: the date the SP exercises its discretion to accelerate a payment and such exercise is irrevocable; and the date a payment has been made under the plan. Remove the SR s discretion to accelerate the payment or otherwise make the acceleration permissible under 409A. Practice Tip: Notice makes explicit that provisions for accelerated payment permitted under Treas. Reg A-3(j)(4) (for example, acceleration to the extent necessary to comply with a domestic relations order, or acceleration to cash out balances less than the I.R.C. 402(g)(1)(B) limit) may be added after a plan has been adopted. The Notice reaffirms the statement in the final regulations that a plan may be amended at any time to include death, disability or an unforeseeable emergency as a payment event Impermissible reimbursement or in-kind benefits provisions Correction may be made before the date an event occurs that would result in the SP becoming eligible to receive a reimbursement or in-kind benefits subject to 409A. Amend the plan to provide for reimbursements or in-kind benefits that satisfy the requirements of 409A. Any amendment required to satisfy the prohibition against allowing the amount eligible for reimbursement, or of in-kind benefits provided, in one year to affect the expenses eligible for reimbursement, or in-kind benefits, in any other taxable year must be allocated pro rata to the number of years during which the SP may be eligible to receive the reimbursements or in-kind benefits (and if available for life, prorated based on reasonable actuarial assumptions). None. If an event occurs that would have made the SP eligible for payment of reimbursements or in-kind benefits under the pre-correction plan within one year following the date of correction, the 50% Income Inclusion Rule applies. Practice Tip: It is not evident how the proration requirement should be applied over periods that do not correspond to calendar years. For example, if an arrangement provided for reimbursement of expenses up to $60,000 incurred over a 24-month period beginning October 1, 2010, the requirement might be understood to require allocation of $20,000 of reimbursement eligibility to each of 2010, 2011 and 2012 or, if the requirement is understood to contemplate fractional years, to require allocation of $7,500 (3/24 of $60,000) of reimbursement eligibility to 2010, $30,000 (12/24 of $60,000) to 2011 and $22,500 (9/24 of $60,000) to 2012.