IRS Introduces Section 409A Document Correction Program
On January 5, 2010, the Internal Revenue Service published Notice 2010-6: http://www.irs.gov/pub/irs-drop/n-10-06.pdf. This Notice contains important information regarding how the sponsors of non-qualified deferred compensation plans can correct plan documents to avoid or reduce significant adverse income tax consequences and penalties.
Section 409A was enacted in 2004 with an effective date of January 1, 2005. It imposes very strict limitations on what provisions are allowable in non-qualified deferred compensation plans. In general, these are compensation plans other than qualified plans (such as 401(k) or 403(b) plans) under which the service provider obtains a vested interest in compensation in a year earlier than the year in which it is paid. Section 409A contains strict and detailed requirements relative to, among other things:
- Timing of elections to defer compensation
- Permissible events that allow payment of benefits
- The ability to accelerate or otherwise alter the timing of payment
- Funding of benefits
The penalties for violating Section 409A can be draconian: taxation to the plan participant of as much as the entire value of his or her account, plus 20% penalty and interest. Plan documents were required to comply with Section 409A by December 31, 2008. The Internal Revenue Service is now beginning to conduct audits relative to Section 409A issues.
Non-qualified deferred compensation plans must comply with Section 409A both in form and in operation. The Internal Revenue Service previously issued Notice 2008-113, http://www.irs.gov/pub/irs-drop/n-08-113.pdf, which addressed correction of Section 409A operational violations. This notice explicitly did not address situations where the plan documents themselves do not comply with Section 409A, and indicated that additional guidance would be forthcoming. Notice 2010-6 is that guidance, and it provides an opportunity (and extension of time) for plan sponsors to correct their plan documents and avoid or reduce exposure to the adverse consequences of Section 409A.
How the Program Works
To be eligible for the relief offered by Notice 2010-6, the plan sponsor must correct the document in accordance with the detailed requirements of the Notice, and must comply with certain information and reporting requirements. Prompt correction is very important, for two reasons. First, the program is not available to taxpayers who are under examination by the Internal Revenue Service. Second, as discussed below, there can be adverse consequences if the defective plan provision is applicable to an event that takes place during the year following correction.
Some of the many types of document failures that can be corrected under Notice 2010-6 include the following:
- A permissible payment event such as “separation from service” or “disability” is either not defined or improperly defined.
- A payment period is more than 90 days following a permissible payment event.
- A payment is dependent upon the participant’s execution of a release of claims or a noncompetition agreement.
- There is an impermissible payment event such as the enrollment of a child in college.
- There are impermissible alternative payment schedules. For example: the payment is a lump sum if the separation is involuntary, but takes the form of annual installments if the separation is voluntary.
The following example illustrates how the program works. Employee X enters into a non-qualified deferred compensation plan under which she is entitled to $100,000 upon the earlier of death, disability, or separation from service. The definition of separation from service includes transfer to a subsidiary corporation, which violates the requirements of Section 409A. On March 1, 2011, the employer amends the plan so that the definition of separation from service no longer covers transfer to a subsidiary corporation. If X transfers to a subsidiary corporation on or before March 1, 2012, then 50% of the amount deferred under the plan becomes taxable to X, and X is subject to the additional 20% penalty tax, even though nothing has been paid to X. If, however, X transfers to a subsidiary corporation after March 1, 2012, no tax or penalty can be assessed.
In order to obtain the benefit of Notice 2010-6, the service recipient is required to attach a statement to its tax return for the year of correction. The statement must be titled “Section 409A Document Correction Under Section [insert appropriate section] of Notice 2010-6” and must set forth certain specific information regarding the correction.
If plan documents are corrected on or before December 31, 2010, then, for purposes of applying Notice 2010-6, the correction is deemed to have been made on January 1, 2009. This can be very important because, as illustrated in the above example, certain adverse consequences are avoided if events occur more than a year after the document is corrected. In order for this relief to apply, the plan must also comply with any applicable operational corrections under Notice 2008-113.
Notice 2010-6 provides an opportunity to amend non-qualified deferred plan documents with reduced or no adverse tax consequences. This notice and Notice 2008-113 enable plan sponsors to correct plan problems in advance of an IRS examination. Therefore, it is important for all deferred compensation arrangements to be reviewed carefully for compliance with Section 409A. Because of the timing requirements of the Notice, and because the notice does not apply to taxpayers under IRS examination, it is important to conduct such a review promptly.
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