Implications under 409A for Operational and Documentation Failures

Congress imposed a rigid tax regime on nonqualified deferred compensation plans by adopting Section 409A of the Internal Revenue Code at the end of 2004.  409A imposes various requirements, such as rules relating to time and form of payment and timing of deferral elections.  409A also imposes three penalties on participants in non-compliant plans:

  • Immediate taxation
  • 20% penalty
  • Interest from the year of deferral (at the underpayment rate plus one percent).

That’s old news, right?  Not exactly.  Although plans should be in compliance at this point, we are finding that some employers never updated their plans for 409A, are not administering their plans correctly, or both.  Fortunately, the IRS has provided limited relief on both counts.

For certain operational failures that are both inadvertent and unintentional, the IRS relief varies based on how soon after the failure the correction occurs and on the status of the participant who needs the relief.  For correcting certain unintentional document failures, reporting of the correction and limited penalties may apply.

Example

The correction procedures are too complicated to effectively summarize in a blog post, but consider the following operational failure we recently encountered to get a sense of what can be involved.

A plan had been updated for 409A, but the plan has not been administered correctly.  The plan provides for vesting at age 65, with an annual benefit of $100,000 payable for five years.  The participant is the employer’s chief executive officer.  However, the parties decide when the participant attains age 65 to defer payment to age 68.  409A does not allow for this type of flexibility.  (Payment dates can be extended under 409A, but the extension must be for at least five years and must be made in writing at least one year before the date of entitlement.)  This year, when the CEO attained age 67, the employer tried to resolve the 409A violation.

The correction procedure for an insider (i.e., the CEO) who fails to receive scheduled payments under the plan, and who corrects the mistake by the end of the second year after the error, is as follows:

  • the employer in 2012 pays the CEO $100,000 for 2010 and $100,000 for 2011;
  • gains in the plan are removed, and the employer cannot pay any interest or other payment to the CEO;
  • the employer and the CEO would need to amend their prior tax returns to include the payments and required taxes;
  • the CEO would pay a penalty amount of $20,000 [i.e., 20% of $100,000] for 2010 and $20,000 for 2011; and
  • the employer and CEO would need to file an information statement with their original, timely returns (contains list of affected employees, name of plan, description of failure and circumstances, describes steps taken to avoid recurrence, and a statement of eligibility).

The employer would then pay the remaining three annual installments in a timely manner under the terms of the plan.

So where does this leave us?  Employers with plans that have never been updated for 409A or that are not being administered correctly should take advantage of the correction procedures and start complying with 409A.  Various types of corrections can be made without penalty, but early correction is the key.