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CCH® PENSION AND BENEFITS — 4/18/08

Self-correction program helps employers avoid 409A penalties

Ensuring that employees do not face significant tax penalties because of the failure of nonqualified deferred compensation plans to comply with Code Sec. 409A requirements necessitates not only identifying and correcting operational failures, but implementing internal controls to detect and prevent errors. Service providers and employers must “monitor the plan, identify and correct quickly” any errors that occur, they must comply with reporting requirements, and they must institute internal controls to prevent recurrence of errors, noted Althea Day, a partner at Morgan, Lewis & Bockius in Washington, D.C. Day offered that advice while participating in a March 19,2008 webcast on “Self-correction of Certain Code Sec. 409A Operational Errors,” sponsored by the American Law Institute and American Bar Association (ALI-ABA). The webcast addressed the types of operational failures that are eligible for the IRS’s limited 409A corrections program and the corrections that need to be made to prevent such failures from inflicting significant tax penalties on participating employees who receive deferred compensation.

409A corrections

Nonqualified deferred compensation arrangements must comply with the requirements of Code Sec. 409A by December 31, 2008. Failure to comply will cause participants to recognize immediate income on vested deferred amounts as well as a 20 percent additional tax and a premium interest tax. Notice 2007-100 (CCH Pension Plan Guide ¶17,137U) provides transition relief and guidance on how to correct certain failures of nonqualified deferred compensation plans to comply with the operational requirements of Code Sec. 409A.

The IRS’s correction program provides permanent relief for correction of certain unintentional, nonegregious operational failures made in the same tax year as the year the error occurred in order to avoid income inclusion under Code Sec. 409A . It also provides transitional relief for correction of certain errors made in a year different from the year that the failure actually occurred in order to limit income inclusion. Among other requirements, the employer bears the burden of establishing that it is eligible for relief and has met all the requirements of the Code Sec. 409A corrections. Additionally, the employer must meet filing and reporting requirements.

Same-year correction

Under the IRS correction program, certain failures corrected in the same tax year as they occurred will result in no income inclusion or additional taxes under Code Sec. 409A . Failures that are eligible for such relief include:

• Insufficient deferrals and incorrect payments made to participants;
• Excess deferrals (i.e., amounts of deferred compensation under a deferred compensation plan that should not be deferred, but are);
• Nonqualified deferred compensation that should not have been paid for at least six months following a participant’s separation from service; and
• Below-market exercise price of stock rights, as long as the stock rights have not been exercised.

To fix an incorrect payment made to a person, an employee must repay the employer the amount incorrectly distributed in the same tax year as the error. Interest must be paid if the amount exceeds $15,500. If this requirement is met, the distribution does not need to be reported on Form 1099 or Form W-2. Also, an employer who defers compensation but should not have may, but is not required to, pay interest to the employee.

Later-year correction

Transitional relief, also called multiple-year correction, limits the amount of income and additional taxes under Code Sec. 409A . As a basic requirement, the correction can be made in the year after the error is made, but no later than by the end of the second tax year after the year in which the failure occurred, explained Carl Toppin, attorney with Paul, Hastings, Janofsky &Walker in Washington, DC, who spoke during the webcast. Eligible errors are limited to:

• Certain insufficient deferrals and certain incorrect payments;
• Violation of the six-month rule (mentioned above); and
• Certain excess deferrals.

For these types of errors, the correction program provides limited relief. For example, the employee will have Code Sec. 409A income inclusion for the amount that should have been deferred but that was distributed to him or her, plus the 20 percent additional tax, which only applies to the amount distributed, not the entire inappropriate amount that was deferred. However, the premium interest tax does not apply.

Filing and reporting requirements

For same-year corrections, Day explained that employers must attach to their tax return for the year of the failure certain documents detailing information associated with the failure and steps taken to correct the failure, as well as the employees affected, including insiders. The employee does not have to provide any notice on his or her tax return, she added, since if the error is corrected in that year there is no income to report. However, under the transitional relief provisions, employees must attach a copy of the employer’s notice to their tax returns.