On January 5, 2010, the Internal Revenue Service announced a program to permit taxpayers to voluntarily correct many types of documentary failures in nonqualified deferred compensation plans; such failures can trigger substantial tax penalties under Section 409A of the Internal Revenue Code.
The correction program, set forth in IRS Notice 2010-6, offers helpful guidance in the use of certain “ambiguous” terms, provides valuable transitional relief through December 31, 2010, and allows (less-generous) relief following the transition period.
Where a plan uses undefined or ambiguously defined ‘payment events’ which could be interpreted as complying with Section 409A but also could be interpreted as not complying with Section 409A, a plan may be amended to clarify those ambiguous terms. Where payment is made under an ambiguous term in a manner not considered proper under Section 409A, the payment may be treated as an operational failure and corrected under existing IRS guidance on operational corrections (IRS Notice 2008-113), provided that the plan is amended by the end of the year in which the operational failure is corrected. Certain terms describing the timing of a payment following a permissible payment event (such as “as soon as practicable following separation from service”) will not be treated as a violation of Section 409A so long as the payment is made no later than the 15th day of the third month following the payment event or, if later, by the end of the service provider’s (employee’s) taxable year in which the payment event occurs.
Generally, plan definitions, payment periods, payment provisions or payment schedules which do not comply with the requirements of Section 409A may be corrected if the corrective plan amendment is adopted before the triggering event occurs. For example, if a plan document’s definition of “separation from service” impermissibly includes an employee switching to an independent contractor, the plan may be amended to correct the definition, provided that the employee has not already had a separation from service. In certain situations, where the impermissible triggering event occurs within one year following the date of correction, a set percentage of the amount deferred under the plan (50% in the case of a separation from service, 25% in the case of a change in control) must be reported as Section 409A income. The correction of a plan which contains no permissible payment events will require establishing a payment date which is the later of (i) separation from service, and (ii) the 6th anniversary of the date of correction. The correction of a plan document error generally requires bringing the terms of the plan into conformity with Section 409A without an expansion of options or rights of the service provider. Certain document corrections may be made even after the payment triggering event has occurred. Faulty initial election provisions (that is, elections about whether to defer compensation, not how and when deferred compensation should be paid) may be corrected by end of the second taxable year following the year in which the election needed to be made. If amounts were not included in income as a result of an improper election provision, they must be treated as an operational failure and corrected under IRS Notice 2008-113.
Where a plan document fails to require a six-month delay on payments to Specified Employees following a separation from service, the plan may be amended under the program if the correction is made before the triggering payment event occurs. The amendment must delay payment until later of (i) 18 months following the date of correction and (ii) six months after separation from service. If the Specified Employee’s separation from service occurs within one year following the correction date, 50% of amount deferred under plan must be reported as income subject to Section 409A.
An employer/service recipient may retroactively amend a plan to correct document errors until the later of (i) the end of the calendar year or (ii) the 15th day of the third month following the date benefits first vest under the plan. If correction can be made under this provision, no one-year look forward and inclusion of income is required. For purposes of determining this deadline, all similar plans maintained by the employer/service recipient must be aggregated.
Notice 2010-6 grants valuable relief for corrections made before December 31, 2010. Corrections made during the transition period are treated as if made on January 1, 2009. In this instance, it may be possible to correct a document error even where a payment triggering event has occurred prior to the actual date of correction. Further, corrections made during the transition period will not be subject to the one-year look forward and income inclusion contained in the regular correction procedures. A separate transition period, through December 31, 2011, exists for linked plans and for deferred compensation based upon accounts receivable and similar contingency-based arrangements.
Relief under IRS Notice 2010-6 is not available if the service provider (employee) or service recipient (employer) is under IRS examination for nonqualified deferred compensation for any year in which the plan existed. However, for corrections made before December 31, 2011, a service recipient will be treated as “under examination” only if a specific document failure has been specifically identified as an issue in an IRS examination.
In addition to amending plan provisions to correct defective plan language, relief under IRS Notice 2010-6 is also conditioned upon certain reporting requirements. The service recipient (employer) must prepare a statement and attach a copy to its federal income tax return for the year in which the correction is made (and, in some cases, for the following year as well). A separate statement must also be provided to the service provider (employee) who must attach it to his federal income tax return. In addition, any amounts required to be treated as income under Section 409A under the particular correction methodology must be reported on Form W-2 or 1099-R as appropriate.
IRS Notice 2010-6 provides valuable relief for taxpayers faced with inadvertent or unintentional document issues in nonqualified deferred compensation plans and agreements. Because the transitional rules permit the avoidance of potentially costly income tax inclusion and because correction is, in many instances, available only where a payment triggering event has not occurred, taxpayers would be well served to review their deferred compensation plan documents to ascertain any potential documentary non-compliance and address the correction of those situations before December 31, 2010.
For more information, please contact your Baker Hostetler attorney, John Boyd ( or 216.861.7910), who was the primary author of this alert, or one of our Executive Compensation attorneys. We hope you find this information helpful.
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