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CCH® PENSION AND BENEFITS — 12/14/07

IRS releases guidance on correcting operational failures of nonqualified deferred compensation plans

The IRS has issued transition relief and guidance on the correction of certain failures of nonqualified deferred compensation plans to comply with the operational requirements of Code Sec. 409A(a) . The transition relief and guidance provide: (1) methods for correcting operational failures during the tax year of the service provider in which the failure occurs to avoid income inclusion and (2) transition relief limiting the amount includible in income for certain operational failures occurring in a service provider’s tax year beginning before January 1, 2010 that involve only limited amounts. The IRS is also requesting comments on a potential corrections program for operational failures of nonqualified deferred compensation plans.

Corrections relief is provided under the guidance to plans that make unintentional errors, such as mistakenly paying out deferred compensation earlier than required by a plan. Plans that correct under this guidance within the service recipient’s tax year can avoid adverse tax consequences. Plans that do not qualify for this corrections relief, but still correct before January 1, 2010, can avoid some of the adverse consequences of plan failure. The guidance provides detailed descriptions of the information that must be provided to the IRS in the event of a plan correction.

Corrections within the service provider’s same tax year

Plans are treated far more generously if they correct an operational failure within the service provider’s tax year. No amount is required to be included in income as a result of an unintentional operational failure if it is corrected, as provided by the new guidance, during the service provider’s tax year during which the mistake was made. Relief is conditioned on the service recipient taking commercially reasonable steps to avoid a recurrence of the operational failure. Information and reporting requirements also apply.

Relief under this guidance is unavailable for: (1) plan terms and provisions that fail to meet the requirements of Code Sec. 409A and relevant guidance; (2) any exercise of a stock right that otherwise would result in a failure to comply with Code Sec. 409A ; (3) any intentional failure to comply with the terms of a plan or the requirements of Code Sec. 409A in the operation of a plan; or (4) an operational failure that is egregious, or where the failure is directly or indirectly related to participation in an abusive tax avoidance transaction. Relief is not available under the guidance with respect to any erroneous payment occurring during any tax year of the service provider in which the service recipient experienced a substantial financial downturn.

In each instance, the taxpayer claiming the relief (the service provider, the service recipient, or both) has the burden of demonstrating that such taxpayer was eligible for the relief and that the requirements of this section have been met. Any application for such relief is subject to examination by the IRS.

Failure to defer amount or incorrect payment corrected in the same tax year. The guidance provides relief for amounts of deferred compensation that were mistakenly paid. An amount to which this relief applies is treated as having been timely paid if the service provider repays the amount to the service recipient within the service provider’s tax year in which the error was made. Immediately after repayment, the service provider must have a legally binding right under the plan to be paid the amount that would have been due if such amount had not been erroneously paid or made available to the service provider during such tax year.

In addition to repayment, service provider insiders who take advantage of this relief must also pay interest to the service recipient at the time the service provider repays the service recipient. Under the guidance, a service provider is considered an insider if the service provider: (1) is a director or officer of the service recipient or (2) is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security of the service recipient. Rules as to how interest is to be calculated and how repayment can be made are also provided in the guidance.

Incorrect payment in violation of six-month delay rule for specified employees. Relief is provided under the guidance for mistaken payments with respect to specified employees subject to the six-month delay rule for separation of service payments. The service provider will not be treated as having failed to comply with the six-month delay rule as a result of the amount being paid or made available at an earlier date if, on or before the last day of the service provider’s tax year in which the amount was paid or made available, the service provider repays to the service recipient the amount that was erroneously paid or made available. Immediately after such repayment, the service provider must have a legally binding right to receive the amount from the service recipient on the date that is the same number of days after the later of (i) the date the amount would otherwise have been payable under the terms of the plan and the applicable deferral election or (ii) the date of the repayment, defined as the number of days from the date the service recipient made the erroneous payment to the service provider through the date the service provider repaid the erroneous payment to the service recipient, and the repaid amount is not paid or made available to the service provider before such date.

Excess deferred amount corrected in the same tax year. If an amount that should not have been deferred compensation is credited to the service provider’s account or otherwise treated as deferred compensation as a result of an unintentional plan operational failure, and this excess amount otherwise would have been paid to the service provider during the service provider’s tax year in which the excess amount was incorrectly credited to the service provider’s account, the excess amount is not treated as deferred if paid to the service provider on or before the last day of the service provider’s tax year in which the excess amount was incorrectly deferred. The amount to which the service provider has a legally binding right under the plan at the end of the year must be adjusted to reflect the payment.

If the service provider is an insider, the remaining account balance (or other deferred compensation under the plan) must be adjusted for positive earnings retroactive to the date the excess amount was incorrectly credited to the service provider’s account or otherwise incorrectly treated as deferred under the plan, provided that the adjustment is made on or before the last day of the service provider’s tax year in which the amount was incorrectly treated as deferred. If it is impracticable to make the adjustment by the end of the year, the service recipient must have a legally binding right on the last day of the tax year to make the adjustment retroactively to such date.

This relief does not apply to a service recipient’s failure to timely pay in the proper taxable year of a service provider amounts that were deferred in one or more previous taxable years of the service provider.

Correction of exercise price of otherwise excluded stock rights. Relief under the guidance is available if a stock right would be excluded from the definition of non-qualified deferred compensation (and hence, the reach of Code Sec. 409A) as an excluded stock option or stock appreciation right, except that the exercise price of the stock right is less than the fair market value of the underlying stock on the date of grant. Corrections relief is available only if the failure of the exercise price to equal or exceed the fair market value of the underlying stock results from an unintentional administrative error in determining the exercise price.

Transition relief for operational failures during tax years beginning before 2010

If an unintentional operational failure occurs during a service provider’s tax year beginning before January 1, 2010, but the failure does not qualify for correction under the rules governing corrections within the same tax year, the failure may nevertheless qualify for limited corrections relief.

The general rules applicable to corrections during a service provider’s same tax year also apply to this transition relief. For instance, the transition relief applies only to unintentional operational failures. In each instance, the taxpayer claiming the relief (the service provider, the service recipient, or both) has the burden of demonstrating that the taxpayer was eligible for the relief and that the specified requirements have been met. Any application of the transition relief provided is subject to examination by the IRS. In addition to correcting the operational failure, the service recipient also must take commercially reasonable steps to avoid a recurrence of the operational failure. For any tax year of the service provider beginning after December 31, 2008, if the same or a substantially similar operational failure has occurred previously, the service recipient must demonstrate that it had established practices and procedures reasonably designed to ensure that such an operational failure would not recur, had taken commercially reasonable steps to avoid a recurrence of the operational failure, and that the operational failure occurred despite the diligent efforts of the service recipient.

The relief is not available for any failure unless all of the requirements (other than the information and reporting requirements) have been satisfied not later than the end of the second tax year of the service provider following the tax year of the service provider in which such failure occurred. In addition, the relief provided is not available if a federal income tax return of the service provider for the tax year in which the failure occurred is under examination with respect to the plan.

Failure to defer limited amount not corrected in the same tax year and certain erroneous payments. Relief is available if, during a service provider’s tax year beginning before January 1, 2010, an unintentional operational failure occurs in which an amount that should have been treated as deferred compensation was not, and was, instead, paid out to the service recipient. In such a case, the amount includible in income as a result of the payment is limited to the amount that should have been treated as deferred compensation under the plan (or should have continued to be deferred compensation under the plan) but was instead paid or made available to the service provider, and does not include any other amounts deferred under the plan. In addition, with respect to such amount includible in income under Code Sec. 409A(a) , the service provider is required to pay the additional 20 percent tax under Code Sec. 409A(a)(1)(B) , but is not required to pay the premium interest tax under Code Sec. 409A(a)(1)(B) . This relief is available only if the amount paid or made available to the service provider does not exceed the limit on elective deferrals that would apply to a qualified plan under Code Sec. 402(g)(1)(B) for the year of the operational failure ($15,500 for 2007 and 2008).

Limited excess deferred amount not corrected in the same tax year. Relief is available if on or before the last day of a service provider’s tax year beginning before January 1, 2010, due to an unintentional operations failure, an amount of deferred compensation under the plan should have been paid but was not, or an amount is treated as deferred compensation under the plan that should have been paid but was not. Relief is conditioned on the amount that should have been paid during that service provider’s tax year, not exceeding the limit on elective deferrals that would apply to a qualified plan ($15,500 for 2007 and 2008) for such year. Under the relief provision, by the later of the end of the service provider’s tax year in which the failure is discovered or the 15th day of the third month following the date upon which the failure is discovered, the service recipient must pay to the service provider the amount that should have been paid or made available. Any earnings allocable to such amounts through the date of the payment must be either forfeited or added to the payment to the service provider, and any losses allocable to such amounts through the date of the payment must be either permanently disregarded or subtracted from the payment to the service provider. The amount includible in income as a result of such failure is limited to the excess amount paid to the service provider, and does not include any other deferred compensation under the plan. The amount is includible in income only when paid to the service provider in accordance with the corrections guidance.

Comments requested on potential corrections program

The IRS is considering establishing a corrections program under which taxpayers could correct certain operational failures, including correction after the end of the service provider’s tax year in which an operational failure occurs. The IRS is requesting comments on all aspects of a potential corrections program, particularly with regard to potential methods of tracking the “investment in the contract” created when an amount is included in income under Code Sec. 409A but not yet paid to the service provider, as well as potential 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.

Comments must be submitted by March 3, 2008. Comments may be submitted to: Internal Revenue Service, CC:PA:LPD:RU (Notice 2007-100), Room 5203, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Alternatively, comments may be submitted via e-mail to Notice.comments@irscounsel.treas.gov and should include the notice number (Notice 2007-100) in the subject line.

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