Treasury and IRS Provide Limited Relief for Operational Failures Under Code Section 409A

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1 January 15, 2008 By John Lowell, Vice President, Aon Consulting This article examines Notice which the Department of Treasury and the IRS published on December 24. Notice provides relief under particular circumstances for certain failures to comply with Internal Revenue Code Section 409A. Christmas came a day early for 409A junkies. On December 24, the Department of Treasury and the Internal Revenue Service (IRS) published Notice , which provides relief under particular circumstances for certain failures to comply with Internal Revenue Code (Code) Section 409A. For those who have managed to ignore this topic for the last three years or so, Section 409A was added to the Code by Section 885 of the American Jobs Creation Act of 2004 (AJCA or Jobs Act). It provides, in general, that any nonqualified deferred compensation that does not meet a fairly onerous set of requirements will be subject to an additional 20% income tax as well as interest penalties from the date deferred. We ve discussed 409A in a number of articles, including focuses on Supplemental Executive Retirement Plans (SERPs) and separation pay plans. Commenters, including attorneys, consultants and various industry lobbying groups have been consistent in saying that the rules previously promulgated by Treasury and IRS are too complex and extremely difficult to comply with in operation. Many have said that even the most diligent service recipients and service providers will occasionally inadvertently fail to comply with all the requirements of 409A in operation. While the Notice is quite complex, this is not surprising given the subject matter. In fact, ERISA practitioners will recognize that this Notice has many similarities to the Employee Plans Compliance Resolution System (EPCRS) program, and that the IRS and Treasury have given this considerable thought and done a quite commendable job. The Notice is laid out in outline form; that is, it is in sections with text rather than in the more difficult to read form that we typically see regulations in. So that a reader who chooses to read the Notice as well can easily cross-reference, we ll go through the highlights of the Notice in the same order as the Notice itself. Generally, the Notice discusses: Corrections of operational failures in the same taxable year as the failure occurs; Transition relief for operational failures occurring during taxable years beginning before 2010; Information and reporting requirements; A potential program to correct other 409A operational failures; and A request for comments. Corrections of certain operational failures in the same taxable year as the failure occurs January 2008 page 1

2 Relief under this Section II is fairly limited. But, when it applies, it is very useful. When this Section II does apply, there is no income inclusion under Section 409A(a), and therefore no additional income tax or interest payments. Let s look at the requirements to satisfy this Section II. In order to qualify for Section II relief, there is a six-prong test that the taxpayer must meet. 1. The failure must be operational (as compared to noncompliant plan terms) and unintentional; 2. The failure must not be with respect to the exercise of a stock right; 3. In addition to correcting the failure during the same taxable year in which it occurred, the taxpayer must take reasonable steps to ensure that the same failure will not occur again; 4. If the same or similar operational failure has occurred in the past, then the failure is not eligible for Section II relief for any taxable year beginning in 2009 or later, unless the service provider can establish that steps were in place to avoid such a recurrence, and the operational failure occurred despite such diligent efforts; 5. The failure can be neither abusive (a listed transaction as defined in Regulation (b)(2)) nor intentional; and 6. The taxpayer must meet the information and reporting requirements of Section IV (see below). Note that in all cases where a taxpayer claims Section II relief, the taxpayer has the burden of demonstrating that the six-prong test has been timely satisfied. The Notice then goes into significant detail on various situations that might be eligible for Section II relief. First among these is the situation where the service provider (employee) has made a bona fide election to defer, but the amount that has actually been deferred is either incorrect or is zero. In either case, we will assume that the operational failure is corrected in the same taxable year. Further, note that the IRS provides a different remedy depending on whether the service provider is an insider (more on insiders later) or not. For now, let s assume that the service provider is not an insider. In this specific case, so long as the service provider repays to the service recipient any underpayment for that taxable year, and does so before the end of the taxable year, then all amounts elected to be deferred by that service provider for that year will be treated as having been timely deferred. On the other hand, if the service provider is an insider with respect to the service recipient (insiders will include officers, directors and 10% percent owners of any class of stock), then the amount to be repaid must include interest at the federal short-term rate. In either case, payment may either be made directly or by the service recipient reducing the compensation of the service provider by the appropriate amount. The amount mistakenly paid is not considered income for the service provider and is not to be reported on either Form W-2 or Form And, if employment taxes have been withheld on the erroneous compensation, appropriate adjustments are to be made. Finally, interest adjustments may be made before the end of the taxable year as legally appropriate. And, to the extent that the January 2008 page 2

3 service recipient experienced significant financial hardship during the period such that it may not be able to pay the amount deferred when it becomes due, corrections of this type are not available. The next paragraph relates to payments which should have been deferred for six months (those to specified employees following termination), but due to an unintentional operational failure either were not deferred or were not deferred for the full six months. If on or before the close of the taxable year, the service provider repays to the service recipient the amount erroneously paid, and the amount becomes available to the service provider X days after the date of the repayment, the six-month rule will be deemed to have been met, so long as X is equal to the number of days from the date the error was made until it was corrected. In no case may that date be earlier than payment was originally allowed to be made. To the extent that repayment is made according to the previous paragraph, no income will be reported for the erroneous payment. When payment is properly made, however, income is to be reported for the proper payment. For the next situation, suppose that the employee inadvertently over-defers. In other words, the employee makes an election to defer one amount, say $10,000, and the employer actually withholds a larger amount, say $50,000. To the extent that the amount is repaid to the employee by the end of the taxable year, it is not to be treated as a deferral. If the employee is an insider, the account balance must be adjusted for positive earnings retroactive to the date the excess amount was incorrectly credited to the employee s account or otherwise treated as deferred under the terms of the plan, provided that said adjustment is made by the end of the taxable year. In all other cases, the account balance may be adjusted, but there is no requirement to do so. The last paragraph in Section II relates to stock rights that properly administered would not have been considered nonqualified deferred compensation within the meaning of Section 409A. This would occur for rights that should be exercisable at or above market value, but due to unintentional administrative error were considered exercisable at a price below market value. Such amounts would not be considered nonqualified deferred compensation if both before the right is exercised and before the last day of the service provider s taxable year, the exercise price is reset to an amount equal to or exceeding the fair market value of the underlying stock. Transition relief for certain small amount operational failures in taxable years beginning before 2010 This Section III applies to operational failures in taxable years beginning before 2010 where the failures are not corrected by the end of the service provider s taxable year. In general, to qualify for Section III relief, the erroneous amount may not exceed the limit under Code Section 402(g)(1)(B) for the year of the operational failure (currently $15,500). January 2008 page 3

4 Again, there is a six-prong test that must be satisfied under this Section III, and the Notice distinguishes between under-deferrals and over-deferrals. The prongs of the test (all must be satisfied) are as follows: 1. The failure must be operational and unintentional; 2. In addition to correcting the operational failure, the service recipient must take reasonable steps to ensure that the same error does not occur again; 3. If the failure occurs in a taxable year beginning after 2008, and the same or similar failure has occurred before, the burden will be on the taxpayer to demonstrate that this failure occurred despite reasonable steps that were in place to prevent its occurrence and that those steps were followed; 4. The notice required under Section IV must be timely filed; 5. All requirements of correction must be satisfied by the end of the second taxable year following the year of the operational failure; and 6. The taxpayer is not currently under examination (including Form 1040) for the taxable year in question, nor is the operational failure egregious or related to participation in a listed transaction. We ll use a few examples from the Notice to illustrate the workings of this Section III. Example 1: Employee makes a timely election to defer 10% of a bonus payable in 2007 pursuant to an account balance plan. The bonus is $10,000. Due to an unintentional operational failure with respect to the plan, Employer defers only 8% of the bonus, or $800, and pays Employee $9,200 (instead of deferring $1,000 and paying Employee $9,000). The amount is not corrected by December 31, 2007, when Employee's account balance is $100,000. As a payment to Employee, Employer must treat the amount as a wage payment for employment tax and reporting purposes, as appropriate, including reporting as income and wages on the 2007 Form W-2. Employer is permitted to report as income under 409A on the 2007 Form W-2 (or 2007 Form W-2c), Box 12, using Code Z, only $200, and Employee is permitted to include in income under 409A for 2007 only $200. Furthermore, Employee is permitted to pay the additional 20% tax only with respect to the $200 (or $40 in additional income tax), and is not required to pay the premium interest tax. As we can see, this relates to the situation where the deferral amount was less than elected. Note that because Section III correction was available, the additional 20% tax is only due on the failure amount, and not on the entire deferral election as would be without Section III relief. Example: Employee, who has a calendar year taxable year, makes a timely election to defer 8% of a bonus payable in 2007 into an account balance plan. The bonus is $10,000. Due to an unintentional operational failure with respect to the plan, Employer defers 10% of the bonus, or $1,000, and pays Employee $9,000 (instead of deferring $800 and paying Employee $9,200). The plan otherwise complies with January 2008 page 4

5 409A and the applicable guidance. Employer discovers the error on February 1, 2008, so that the excess deferred amount of $200 is not corrected by December 31, On March 1, 2008, at which time Employee's account balance includes $15 in earnings on the excess $200 credited to the account, Employer pays Employee $215. Employer reports the $215 as income under 409A on the 2008 Form W-2, Box 1 and Box 12, using Code Z and satisfies the other applicable requirements of this III, including the requirements of IV of this notice. Provided that Employee reports such income and pays the applicable taxes, including the additional 409A taxes, on a timely filed 2008 Form 1040 (including a 2008 Form 1040 filed under extension, but not an amended 2008 Form 1040), and satisfies the applicable requirements of Section IV of this notice, Employee is not required to include any additional amounts deferred under the plan in income under 409A(a) or to include any amount in income under 409A for years before 2008, and with respect to the $215 includible in income under 409A is required to pay only the additional 20% tax (or $42.50 in additional income tax), and not the premium interest tax. Employer may also have paid Employee only the $200 excess deferred amount if the $15 in earnings on such amount were forfeited. In this case, where the amount in question is an over-deferral, because the Employee is eligible for Section III relief, only the over-deferral plus earnings is subject to the additional 20% tax, and as in the prior example, the failure does not cause a premium interest tax to be due. Information and reporting requirements The information and reporting requirements under this Notice are quite complex. Before we are to be too critical, however, recall that the IRS and Treasury are giving taxpayers an opportunity to mitigate their tax bills due to 409A failures, where such mitigation was not originally provided for by regulation. That said, one almost wonders how taxpayers will comply with these requirements without the assistance of a Notice specialist. The Notice distinguishes between Section II (same year corrections) and Section III (small amount transitional corrections). For Section II corrections, any service recipient described in that section must attach to a timely-filed (with extensions) original federal income tax return for its taxable year in which the applicable failure occurred a statement entitled 409A Relief Under Section II of Notice and containing a statement that it is relying on Section II of Notice with respect to a correction of a failure to comply with Code Section 409A and describing the following with respect to each such failure: a. The name and taxpayer ID of each service provider affected by the failure and whether each service provider is an insider with respect to that service recipient. If the same or similar failure relates to multiple service providers, then as long as they are clearly identified in a., the information in b. through e. need not be repeated. b. The identification of the plan with respect to which the failure occurred. January 2008 page 5

6 c. A description of the failure and the circumstances under which it occurred, including the amount involved and the date of the failure. d. A description of the corrective steps taken and the date of completion of the correction. e. A statement that the operational failure is eligible for the correction under the terms of Notice , and that the service recipient has taken all required actions and met all requirements for correction. Further, (except with respect to stock rights corrections under Section II) the service recipient must provide the following to each service provider affected by the correction of a failure: a. A statement that the service provider is entitled to relief as provided under Section II of Notice with respect to a failure to comply with Notice b. The information in b. through e. above that the service recipient must provide as an attachment to its tax return. For service recipients using Section III relief under Notice , they must attach to their timely-filed (with extensions) federal income tax return for the taxable year in which it discovers a failure a statement entitled 409A Relief under Section III of Notice Such statement must contain the information described below in a. through e., and must be made by the deadline for providing Form W-2 or 1099 for the calendar year in which the failure was discovered. a. The name and taxpayer ID of each affected service provider. Again, where the same or similar failure occurred with respect to multiple service providers, the information in b. through e. need only be provided once, so long as the service providers to whom the failure applied are clearly identified. b. Identification of the nonqualified deferred compensation plan in which the failure occurred. c. A description of the failure and its surrounding circumstances, including the amount involved and the date it occurred. d. A description of the steps taken by the service recipient to avoid a recurrence of the failure, including the date on which those steps were implemented. e. A statement that the operational failure is eligible for correction under the terms of Notice and that the service recipient has taken all actions required and met all requirements for such correction. In addition, service recipients must provide to each service recipient affected by the failure a statement entitled 409A Relief Section III of Notice This statement must contain the following information: a. A statement that the service provider is entitled to the relief in Section III.B or III.C of Notice with respect to a failure to comply with Section 409A and that the January 2008 page 6

7 service provider must attach a copy of this statement to his federal income tax return. b. The information in b. through e. above. Potential program to correct other operational failures The Notice indicates that Treasury and the IRS are considering a program to correct other 409A operational defects. They are seeking comments on this potential program. As laid out, the potential program would make permanent the transition program under Section III. It is also anticipated that a service provider who uses the potential program to correct an operational failure would only be subject to additional taxation on the defective amounts and not all other deferred compensation under the plan. In addition, IRS and Treasury anticipate that potential program would include much of the following: Relief would only be available with respect to an operational failure that has occurred notwithstanding the service recipient's reasonable efforts to comply with the terms of the plan. Thus relief would only be available if the service recipient had established practices and procedures reasonably designed to ensure compliance with 409A. Relief would only be available with respect to an operational failure if the service recipient also took commercially reasonable steps to avoid a recurrence of the same type of operational failure. Relief would also not be available to correct an operational failure that is egregious, intentional, or where the failure is directly or indirectly related to participation in an abusive tax avoidance transaction (meaning any listed transaction under (b)(2)). If the operational failure involved an accelerated payment that did not otherwise satisfy the plan's terms and the requirements of 409A(a), the correction of the failure would require that the service provider return to the service recipient the amount improperly paid by the service provider to the service recipient. The service provider would not be entitled to any loss or deduction for either the year of the repayment or the year to which the correction applied. If the plan does not otherwise violate the provisions of 409A and the applicable guidance, however, the service provider would be required thereafter to include in gross income only additional amounts subsequently paid from such plan. In other words, the violation would be treated as if the incorrect amount was actually included in gross income for the year of the erroneous payment. Relief would not be available for an accelerated payment that did not otherwise satisfy the terms of the plan and the requirements of 409A(a) if the service recipient made the payment proximate to (a) a financial downturn of the service recipient, or (b) the service recipient experiencing any financial or other issue that indicated a significant risk that the service recipient would not be able to pay the amount deferred when the payment became due under the plan. January 2008 page 7

8 If the operational failure involved an amount that was improperly deferred (for example, the deferral of salary in excess of the applicable deferral election under the terms of the plan), or an amount of deferred compensation that was not paid to the service provider on the date applicable under the terms of the plan, the correction of the operational failure would require that the service recipient pay the amount to the service provider. The service provider would be required to include the amount in gross income in the service provider's taxable year in which the failure occurred and not at the time the service recipient made the corrective payment, with the service provider being required to report the amount on an original or amended return for such year and pay the appropriate tax thereon. Investment earnings (potentially including losses) in accordance with the terms of the plan for the period of time after the operational failure through the date of correction would be required to be taken into account. In addition to the requirement of income inclusion described above, the service provider would be required to pay income taxes, including the additional 409A taxes (and any applicable interest on the underpayment of such 409A taxes), as applicable. The service recipient would be required to file with the IRS and provide to the service provider a Form W-2c or corrected Form 1099, as applicable. If the service recipient and service provider met the requirements for the correction program, the service recipient would not be liable for any failure to withhold income taxes on the amount required to be included in income under 409A as a result of the operational failure, to the extent the amounts required to be included in income had not been paid or made available to the service provider. Some or all of the relief may be available only to service providers that are not insiders with respect to the service recipient. IRS and Treasury seek comments with respect to both Notice and the proposed program. The Notice gives two specific areas where they seek input from the public. They are: 1. With respect to the potential program under consideration, methods of tracking the investment in the contract created when an amount is included in income under 409A but not yet paid to the service provider. 2. With respect to the potential program under consideration, methods of addressing the service recipient's deduction for payments made, and the effect of repayments by the service provider to the service recipient on such deductions. ##### For more strategies on retirement programs, contact John Lowell at or john.lowell@aon.com. January 2008 page 8