The IRS has finally issued long-awaited additional guidance on how to correct non-qualified deferred compensation programs that are not in written compliance with the rules imposed under Internal Revenue Code (the “Code”) Section 409A. Code Section 409A imposes significant restrictions on the manner in which compensation can be deferred from the year in which it is earned to a later year. Failure to properly comply with the rules imposed under Code Section 409A can result in immediate taxation of the full amount deferred under the program or agreement, an additional 20% excise tax and interest.
Previously, the IRS released guidance on how to correct certain operational failures involving non-qualified deferred compensation programs. That guidance, issued in Notice 2008-113, however, did not provide a method to correct problems when the non-qualified deferred compensation program documents failed to meet the written plan requirements of Code Section 409A. Programs that deferred compensation and that were not otherwise exempted under the rules were required to be in written form in compliance with Code Section 409A by January 1, 2009. In the new guidance, issued in Notice 2010-6, the IRS has now provided additional clarity on determining compliance with the operational requirements imposed under Code Section 409A and, significantly, transitional relief on correcting defects with the written plan requirements. This is the first time the IRS has provided guidance on correcting a failure to meet the written plan requirements.
The new rules were adopted by the IRS to motivate taxpayers to review their non-qualified deferred compensation programs to identify potential non-compliance. As with many other types of compliance programs initiated by the IRS, the new guidance strongly encourages self-review and correction. As such, many of the correction provisions of IRS Notice 2010-6 are not available after 2010 or if the taxpayer or applicable plan is under audit. This is of particular interest because the IRS has begun initiating audits of non-qualified deferred compensation plans and has indicated that such audits will be conducted more frequently in the near future.
For plans that meet the requirements imposed under Notice 2010-6, self-correction, in some circumstances, still involves the payment of a portion of the tax obligation that would have been incurred under Code Section 409A. Nonetheless, Notice 2010-6 provides methods to correct voluntarily a number of types of non-compliance with the written plan document requirements applicable under Code Section 409A. In particular, the Notice provides the following:
- Where plan provisions specify that payments will be made “as soon as reasonably practicable,” or substantially similar language, following a permissible payment event, such language will not automatically result in a document failure unless there is a pattern or practice of delaying distributions beyond the time permitted under Code Section 409A.
- Where terms or language in the agreement is ambiguous or could be construed in different ways, one of which is not in compliance with Code Section 409A, the presence of a general provisions confirming that the plan provisions will be interpreted in a manner to comply with the requirements of Code Section 409A can, unless there is a pattern or practice of interpreting the language in a different manner, act to bring such language into compliance with the requirements of the Code.
- If a definition of a payment event under the non-qualified deferred compensation program does not meet the Code Section 409A requirements for such event, such definition may be correctable if such event has not occurred as of the date of correction. If the event occurs within one year of the correction, depending on the provision corrected, some portion of the taxes that would have previously been payable had the correction not been made will be due. The portion depends on the provision that was corrected. For instance, correcting the definition of a “change in control event” to bring it into compliance will result in a payment of taxes on 25% of the amount involved if the change of control occurs within the one year period following the correction. Also, correcting the definition of a termination event to clarify that it is limited to when there is a “separation of service” will result in 50% of the amount involved becoming taxable if a termination that would have called for an impermissible distribution takes place within the one year period following the correction.
- Certain other defects in the written plan documentation can be corrected without the payment of any current income taxes or penalties if they are corrected before the end of 2010 and the event that would have impermissibly triggered taxable income or penalties under Code Section 409A does not occur within the 12 month period following the date of the correction.
- The Notice describes other defects in the written plan documentation that may be corrected using the transition guidance issued under Notice 2010-6. In such event, if operational noncompliance occurred in the program prior to the time of such correction, it may still be necessary to utilize the correction measures permitted under the prior IRS correction guidance issued for non-qualified deferred compensation programs in Notice 2008-113.
IRS Notice 2010-6 offers companies that sponsor non-qualified deferred compensation plans another opportunity to correct certain non-compliance problems with the programs before the end of 2010. This is only intended to be a brief review of the some of the guidance issued by the IRS in Notice 2010-6. However, if you sponsor or participate in a non-qualified deferred compensation program, IRS Notice 2010-6 may offer you an opportunity to retroactively correct any non-compliance that may exist in a manner that will greatly reduce tax inclusion and penalties. As such, we recommend that you review your non-qualified deferred compensation programs to determine whether you can take advantage of the correction and transition opportunities provided by the new guidance.
If you have questions, please contact John Wirtshafter, Michael Riley or any of our Executive Compensation and 409A Compliance attorneys by clicking on the link below.
John M. Wirtshafter
Michael G. Riley
Executive Compensation and 409A Compliance
Large and small employers need to attract, motivate and retain executive talent. We help clients deal with their most valuable assets: their key executives. This may involve advising entrepreneurs and start-up companies about structuring business entities to create equity incentives, or advising compensation committees of public companies regarding best practices and compliance in the rapidly developing area of non-qualified deferred compensation or executive compensation proxy reporting.