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.
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.
A key IRS attorney said last week that the § 457(f) regulations will be used as a vehicle to do some § 409A "clean-up." He also referred to the initial guidance being proposed rules. These comments seem to indicate that the regulations are moving forward, are broader than originally thought, and have a better chance of receiving earlier rather than later attention. The indication that they will come out in proposed form is positive news as it will not only give a chance for comment, but a longer period for easing into the new rules. From: bna.com
Recent chatter about the new 457(f) regulations being published in September may have been premature. Cheryl Press, the senior IRS attorney who was quoted as targeting the September date, on June 15 stated that her projection might be "wishful thinking." She noted that healthcare regulations continue to demand a lot of time. She continued, "We're very slim staffed and our higher-ups are at an even slimmer level. And once we clear [the proposed regulations] through our building and work through everything, we have to get it through Treasury, and they're pretty slimly staffed too."
Regarding the substance of the new regulations, Press reiterated that the regulations will be "similar" to the 409A rules (e.g., disallow pre-tax voluntary deferrals and the use of noncompete restrictions to defer taxes), but that the IRS is not "going to worry about having everything being exactly the same as 409A."
For those keeping track, August 2011 will be the fourth anniversary of the original IRS announcement that it would publish the new regulations. Only time will tell how much longer we must wait.
After nearly a year's silence, Cheryl Press, an IRS Senior Attorney working on the regulations, addressed the regulations on March 10, 2011. Speaking at a conference, she did not address when the regulations might be issued, but instead described a couple of provisions that had not previously been discussed. In addition to addressing substantial risks of forfeiture (presumably moving to the Section 409A non-elective, cliff vesting only model), Ms. Press said that the regulations will also cover illness and vacation leave, and what they require to be deemed "bona fide" arrangements that are exempt from the substantial risk of forfeiture requirement. Regarding the illness and vacation leave, she expressed concern that these arrangements are being used to increase 403(b) deferrals (presumably the ability to convert illness and vacation leave accruals to 403(b) contributions at the time of termination), or to be a type of "savings account" where the participant can take funds out and put them back in.
The last word we had from Ms. Press regarding the timing of the regulations was in April 2010, when she said the regulations were "substantially done." The new comments may signal they are not so far away from being published. But then again ...
As employers consider changes to their key employee benefit packages, many ask whether they can change their current nonqualified deferral plans, and if not, whether they can terminate their plans and start over. Options are available, but careful attention must be paid to 409A to avoid penalties. The general principles are:
- For prior accruals, payment of benefits cannot be accelerated. Payment can be postponed if the change is made at least 12 months in advance, and if the payment is postponed at least five years.
- For future accruals, changes must be made by December 31 preceding the first day of the plan year in which the changes are to take effect.
- Benefit accruals can be frozen at the end of any year, and then held until payable under the normal terms of the plan.
- Plans can be terminated and benefits distributed early if:
- All plans in the same category (e.g., account balance) are terminated
- No benefits are paid for 12 months
- All benefits are paid in months 13 to 24 after the termination
- The employer does not adopt a plan in the same category for at least three years after the termination (the employer can adopt a plan in a different category or an exempt plan (e.g., short-term deferral plan))
- Interests of individual participants in a plan can be terminated and distributed early if the participant’s total benefits from all plans in the same category are paid out, and if the total amount distributed is less than the annual deferral limit (i.e., $16,500 in 2010).