February 11, 2009 By John Lowell, Vice President, Aon Consulting Under Code section 409A, there are two key types of failures those that are from a failure to properly document a plan and those that are from a failure to administer the plan according to its terms. For operational failures (a failure to administer the plan according to its terms), all is not lost. In this article, we discuss the new program from the IRS and Treasury that provides for limited relief from operational failures. The key message act quickly. During December 2008, the IRS and Treasury issued three key pieces of guidance related to Code section 409A (1) guidance related to correcting certain operational failures under 409A, (2) guidance on reporting and wage withholding under 409A and (3) proposed regulations on income inclusion for failures to comply with 409A. In this article, we address that first piece of guidance. Readers should consider that the three pieces of guidance are intentionally intertwined and that consideration of any one without consideration of the other two will likely leave many questions unanswered. Readers may recall that in December 2007, the IRS and Treasury published Notice 2007-100 providing a temporary program under which employers could correct operational (but not documentary) failures occurring prior to 2009 under certain nonqualified deferred compensation programs described in Code section 409A, and either mitigate or completely eliminate the associated tax penalties. Notice 2008-113 describes a similar program for certain failures that occur after 2008. Again, the guidance is long and complex, and addresses many particular situations with significant specificity. In this article, we seek to give an overview of the new guidance, explain its limitations and show the benefits of constant monitoring of 409A plans so that any operational failures can be caught and corrected while the associated penalty is either small or will be waived. Operational failures As noted above, the new guidance provides relief for operational failures. In short, an operational failure in a 409A plan can fall into two broad categories: the failure to operate the plan in compliance with 409A, or the failure to operate the plan in accordance with the plan document. Whether relief is available and the scope of that relief will vary generally depending on three factors: the type of operational failure, February 2009 page 1
whether the service provider (employee) is an insider, and the timing of the correction (year of the failure, year after the failure, later than that). In addition, relief is not available if the employer suffers a substantial financial downturn during the year, or if the service provider is currently under IRS examination. And, the employer must establish procedures to ensure that such a failure does not happen again in the future. To the extent that the failure is part of a pattern of repeating failures, it is likely that it will not be eligible for relief under this notice. Documentary failures The final 409A regulations specify that all plans subject to 409A must be in writing on or before December 31, 2008. To the extent that a plan was not in writing and compliant by that date, that plan has a documentary failure. But, this does not mean that there is a permanent problem with respect to that plan. The recently released income inclusion regulations make clear that a failure occurring in 2009, for example, does not cause a 2010 failure, if the defect is cured before 2010. Thus, even though documentary errors are not eligible for Notice 2008-113 correction, there is significant motivation to cure any such defects, because doing so will save plan participants from adverse tax consequences in future years. Categorizing operational failures The notice divides corrections into several broad groups, where each group is treated differently than the others. corrections of certain operational failures in the same taxable year as the failure corrections of certain operational failures involving non-insider service providers in the taxable year immediately following the taxable year in which the failure occurs relief for certain operational failures involving limited amounts relief for certain other operational failures We will cover each of these groups separately. Corrections of certain operational failures in the same taxable year as the failure One failure that fits into this group occurs when an amount that should be payable to a participant in a future taxable year is inadvertently paid during the current taxable year February 2009 page 2
(failure to satisfy the six-month delay rule is covered elsewhere). If three corrective conditions are met, then no income is included under 409A. The participant repays the erroneous amount to the employer on or before the last day of the participant s taxable year. Or, if such repayment would cause significant financial hardship, the participant (may not be an insider) may, in the alternative, enter into a legally binding repayment plan ending not later than 24 months after the extended due date for the participant s tax return for the taxable year of the failure. The repayment must include interest at the short-term applicable federal rate (AFR) specified in Code section 1274(d)(1). After the repayment is made, the participant has a right to be paid the amounts due to him at the same time and in the same form as would have been available had the failure never occurred. If the participant is at any time during the year an insider with respect to the employer and the amount erroneously paid exceeds the so-called 402(g) limit ($16,500 for 2009), then the repayment must occur during the same taxable year of the failure with respect to the participant and interest must be timely repaid at the short-term AFR. A second class of failure in this group occurs when an amount is paid to a participant from a 409A plan during the same taxable year, but 30 days or more prior to the due date, or when a payment is made not more than six months prior to the due date where the due date has been pushed back for the six-month delay for specified employees. No income inclusion will be required if the participant repays the amount to the employer during the same taxable year, and the new date on which the payment is made again is the same number of days after the date that the amount originally would have been payable as the number of days early that the payment was originally made. A third class of failure in this group occurs when the amount that is deferred under a plan for a year exceeds the amount that should have been deferred under the terms of the plan. No income inclusion under 409A is required if: The excess amount is paid to the participant on or before the last day of the taxable year of the error. The amount to which the participant has a legally binding right under the plan is adjusted to reflect that payment. If the participant was an insider with respect to the employer at any time during the participant s taxable year, then before the end of the taxable year, the participant s account balance must be adjusted for earnings (adjustment for losses is optional) before the end of the year. February 2009 page 3
The fourth and final class of failure in this group relates to stock rights that would not result in the deferral of compensation except that the stock rights had been inadvertently mispriced. Should this occur, if the exercise price of the stock right is reset to a price greater than or equal to the grant date value of the stock before such rights are exercised, then there is no income inclusion required under 409A. Corrections of certain operational failures involving non-insider service providers in the taxable year immediately following the taxable year in which the failure occurs Again, this group of failures includes several classes. The common bonds are the timing of the correction (next taxable year) and that the associated service provider is not an insider at any time during the taxable year that coincides with the failure. Readers should note that if multiple participants have the same such failure in a taxable year with respect to the same plan, then those participants who are not insiders are eligible for this relief, but insiders are not eligible. The first class of failure in this group is a payment that was erroneously paid to the participant during the immediately preceding taxable year (not including six-month delay failures) and repayment (plus interest) is made during the year following the taxable year of failure (in the case of immediate and heavy financial need, binding agreements such as those described in the prior section may be used). Immediately after the repayment, the employee must have the identical rights to payment under the plan that he would have had the failure not occurred. For the year in which the failure occurred, the amount erroneously paid is treated as wages on Form W-2. For the year after the failure (the year of repayment), the repayment, but not the interest may be taken as a deduction. The second class of failure in this group occurs when a payment is made too early during the correct taxable year, but more than 30 days prior to the later due date, or because the payment violated the six-month delay rule for specified employees. To qualify for the treatment under this notice, the amount erroneously paid must be repaid during the immediately following taxable year, and the participant s rights under the plan must be the same as they would have been had there been no erroneous payment. The exact tax treatment will vary here depending on the years of payment, but 409A income inclusion will not be required. The third class of failure relates to amounts that were erroneously deferred in a taxable year and a correction was made in the next taxable year. Provided that the account balance is appropriately adjusted for interest, no income inclusion is required under 409A. The fourth and final class of failure in this group relates to otherwise excluded (nondiscounted) stock rights which were inadvertently priced at a discount. If the stock right is repriced to be nondiscounted before the end of the immediately following taxable year and February 2009 page 4
the stock right has not been exercised before that repricing, then no income inclusion is required under 409A. Relief for certain operational failures involving limited amounts This group relates to operational failures where the dollar amount of the failure is not greater than the 402(g) limit for the taxable year in question. And, in order to qualify, the failure must be corrected and amended tax returns filed no later than the end of the second taxable year of the participant following the year in which the failure occurred. The first class of failure in this group occurs when an amount should have been deferred or should have remained deferred in the plan, but was erroneously paid to the participant, and was not repaid during the same taxable year (note that for non-insiders, better treatment may be available under the rules for the immediately preceding group of failures). If failures under this class are timely corrected, the 20% tax under 409A is still due for the included income, but the premium interest tax is waived. We can illustrate by a simple example. A participant in a deferred compensation plan is inadvertently paid $10,000 from a deferred compensation plan on July 1, 2009. On April 1, 2011, the error is discovered and he repays that amount. So long as all proper reporting is done on or before December 31, 2011 (end of the second taxable year following the year of the error), the participant would owe $2,000 (20% of $10,000) under 409A, but would not be subject to interest penalties as well. The second class of failure in this group occurs when a participant erroneously over-defers into a deferred compensation plan by an amount not greater than the 402(g) limit. Provided that the employer corrects the error by paying the amount plus earnings to the participant, and reports the paid amount in Boxes 1 and 12 on Form W-2 using Code Z, if the employee reports the income and pays the applicable taxes including the 20% 409A tax, then no future years will be considered tainted, and the premium interest tax is waived. Relief for certain other operational failures This group of failures is essentially the same as in the last group, except that the amount of the failure exceeds the 402(g) limit. That is, the error was corrected by the end of the participant s second taxable year following the year of the failure. The first class of failure within this group relates to an amount erroneously paid to the participant (but not a failure of the six-month delay rule) during a taxable year. To qualify under this class, repayment must be made by the end of the second taxable year following the year of the error. In the case of an insider, such repayment must include interest. The erroneous payment must be reported under Box 12, Code Z of Form W-2 for the year of the error. The participant must include the erroneous payment in income under 409A and pay the additional taxes, but not the premium interest tax, with an original or amended tax return. He may not claim a deduction for the repayment in the year in which he makes the repayment. February 2009 page 5
The second class of failure relates to amounts that were paid too early during the same taxable year, or because of a failure to satisfy the six-month delay rule for specified employees. If before the end of the second taxable year following the year of the failure, the participant repays the employer and, immediately after the repayment, the participant has a right to receive the amount the same number of days after the repayment as the number of days early that the payment was originally made, then there is includible income under 409A, but the premium interest tax is waived. The third and final class of failure in this group occurs when an employee over-defers into a nonqualified deferred compensation plan. By the end of the second taxable year following the year of the error, the employer must repay the participant for that over-deferral. The participant must include the amount in income for the year in which it was scheduled to be paid by filing an original or amended tax return, and the amount must be included in income under 409A, but the premium interest tax will be waived. General information on this guidance The guidance in Notice 2008-113 is quite complex. While we have touched briefly on each of the remedial treatments discussed in the notice, there are many details that we have ignored. The general message is the same, however: the sooner you can fix a 409A problem, the better. If you are able to fix the problem soon enough, some or all of the tax penalties may be waived. But, the process is quite onerous. Our recommendations are quite simple: 1. Be the exception don t have any operational failures under 409A. 2. If you re not the exception, catch your errors quickly. 3. You may need help and Notice 2008-113 is useful. If it applies to you, take advantage of it. ##### For more strategies on retirement programs, contact John Lowell at 404.264.3088 or john.lowell@aon.com. February 2009 page 6