Employers must act by the end of 2009 if they want to take advantage of transition relief provided by Notice 2008-113 (the Notice) for certain types of operational violations of the rules under Internal Revenue Code Section 409A that occurred prior to 2008.
Section 409A. As discussed in many of our prior client alerts, Section 409A imposes adverse tax consequences on participants in nonqualified deferred compensation arrangements that fail in form or in operation to meet the requirements of Section 409A at any time during a taxable year. Those adverse consequences include the following:
- The total amount deferred under the plan (and all plans of a similar type) for that year and all previous years is currently includible in income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.
- An additional income tax is imposed equal to 20 percent of the deferred compensation.
- An additional tax is imposed equal to the interest, calculated using the underpayment rate plus 1 percent, that would have been imposed during the deferral period on the underpayment amount that would have occurred if the deferred compensation had been includible in income when first deferred or, if later, when no longer subject to a substantial risk of forfeiture (often referred to as the premium interest tax).
Section 409A applies to independent contractors as well as employees. For simplicity we refer to these individuals collectively as “employees” and the entities for whom they perform services as “employers.”
General Notice Relief. The Notice, which was issued in December 2008, permits the correction of certain limited categories of operational failures under Section 409A with varying degrees of relief from the sanctions of that Section, depending on the nature of the violation and the correction approach used. The Notice outlines the terms and conditions for the permitted corrections, prescribes information and reporting requirements that must be satisfied for relief, and outlines the tax consequences associated with different types of corrective action. In general, the following categories of failures are eligible for relief if corrected in the same taxable year (Same Taxable Year Correction): (i) a failure to defer an amount or incorrect payment of an amount payable in a subsequent year, (ii) the incorrect early payment of an amount payable in the same taxable year or a payment that fails to satisfy the required six-month delay for certain key employees following separation from service, (iii) the deferral of amounts that should not have been deferred or treated as deferred compensation, and (iv) the correction of the exercise price of otherwise excluded stock rights.
In addition, provided that the employee was not an insider at any time during the employee’s taxable year in which the failure occurred, or at any time during the immediately following taxable year, those same categories of failures are eligible for correction under the Notice if corrected no later than the end of the taxable year following the taxable year in which the error occurred (Subsequent Taxable Year Correction). An “insider” is defined as a director or officer of the employer, or direct or indirect beneficial owner of 10% or more of any class of equity security of the employer determined in accordance with the rules under Section 16 of the Securities Exchange Act of 1934, without regard to whether the employer has any class of equity securities registered under Section 12 of such Act. Errors corrected under either the Same Taxable Year or Subsequent Taxable Year Correction approach are not subject to the 20 percent tax or the premium interest tax. The Notice also includes certain other correction approaches, but in general those approaches require correction by the end of the second taxable year after the taxable year in which the failure occurs and payment of the 20 percent tax. It should be noted that correction of each type of failure under any of the approaches provided by the Notice must satisfy numerous requirements not described in this alert.
Limited Transition Relief under the Notice. Section VIII of the Notice contains a special transition rule that is available only for employees who were not insiders at any time during the employee’s taxable year in which the failure occurred. Under the transition relief, for purposes of correcting an operational failure of the type described in clauses (i), (ii) or (iii) above that occurred on or before December 31, 2007, the employee’s taxable year ending in 2009 will be treated as the taxable year next following the taxable year in which the failure occurred. Thus, an employer may correct, in 2009, an error that occurred before 2008 and treat such correction as a Subsequent Taxable Year Correction (thereby avoiding the 20 percent tax), provided that the other terms and conditions of the Subsequent Taxable Year Correction approach are satisfied. (The Notice contains a related liberalization of one of the conditions of the Subsequent Taxable Year Correction approach for certain premature distributions.)
The special transition relief period ends December 31, 2009, and is not available for errors committed in 2008; hence, employers who wish to take advantage of the Subsequent Taxable Year Correction approach for an error occurring in 2008 (and to avoid the 20 percent tax), must also make such a correction by December 31, 2009.