The Internal Revenue Service has delivered a belated but welcome bit of news to compensation committees and corporate tax departments: a correction program to let companies fix errors in their deferred-compensation plans, so those plans can be brought into compliance with Section 409A of the tax code.
Revisions to Section 409A went into effect at the end of 2008, and companies have been enduring compliance headaches with the cumbersome new rules ever since. Tax penalties for non-compliance are severe, both for companies issuing the deferred-compensation plans and the employees who receive them. At the end of 2008 the IRS published guidance to help companies fix operational errors in their pay plans. On Jan. 5, the agency published yet more guidance to help companies correct documentation errors—which, while small and easy to overlook, still carried the risk of a nasty tax bite for the non-compliant.
Cohen
Sandra Cohen, a partner at the law firm Osler Hoskin & Harcourt, describes the new guidance as “extremely helpful” and says employers “should be breathing a huge sigh of relief.”
Under Section 409A, the documentation required to support deferred-compensation plans is formidable. Until now, however, companies had no path to fix defects in the agreements, says Daniel Hogans, a former Treasury Department official who helped write the Section 409A rules and who now works at law firm Morgan, Lewis & Bockius.
Berg
The guidance provides companies a chance to fix most plan document errors, says Brenda Berg, of counsel in the law firm Holland & Hart, such as payment definitions, timing, and compliance with initial deferral elections.
Berg and other experts urge companies to review their deferred-compensation plans in light of the guidance, since many might not have done so since they first revised their plans to comply with the regulations back in 2008.
Pinheiro
“The majority of employers made changes to their plans two or three years ago,” says Brian Pinheiro, chair of the executive compensation practice at Ballard Spahr. “This gives them a chance to fix something they put in place before that might not work upon further consideration” based on additional guidance issued since then.
“409A is a real hammer, and there are real penalties associated with it. I fully expect to see 409A audits in the next five years.”
—Brian Pinheiro,
Chair, Exec Comp Practice,
Ballard Spahr
For example, he says, some companies may need to fix a payment date that varies based on the executive’s execution of a release of claims. Employers often use language that restricts a compensation payment for separation of service subject to a release of claims “within 90 days”—which isn’t permissible under the rules, since the employee can manipulate when the payment is made. Under the correction program, that can be fixed by changing the plan’s language to provide for payment on the 90th day.
Cohen and others also say the relief may be helpful for companies involved in mergers or acquisitions, since acquirers who inherit non-compliant compensation plans may be able to fix those errors with limited penalties.
Get Moving
The IRS is also extending special transition relief until Dec. 31, 2010, to let companies avoid penalties and income inclusion that otherwise would be required if document errors aren’t fixed by then. Once that transition relief expires, the requirements for making some corrections can “still have pretty big tax consequences,” Hogans says. For instance, if an employer corrects a bad distribution provision after 2010 and that provision is triggered within a year following the fix, the employee still gets zapped for half of the bad tax consequences, he says.
Hogans
“The [guidance] provides broad relief to fix document errors in 2010 with fairly limited downside,” Hogans says, “but after that, it’s a mixed bag.”
409A GUIDANCE
Below is an excerpt of IRS guidance outlining some of the provisions of the new Section 409A correction program:
Clarification that certain language commonly included in plan documents will not
cause a document failure.
Relief permitting correction of certain document failures without current income
inclusion or additional taxes under § 409A, provided, in certain circumstances,
that the corrected plan provision does not affect the operation of the plan within
one year following the date of correction.
Relief limiting the amount currently includible in income and the additional taxes
under § 409A for certain document failures if correction of the failure affects the
operation of the plan within one year following the date of correction.
Relief permitting correction of certain document failures without current income
inclusion or additional taxes under § 409A, if the plan is the service recipient’s
first plan of that type (disregarding any plans not subject to § 409A or any plans
under which all deferred amounts have previously been paid or forfeited) and the
failure is corrected within a limited period following adoption of the plan.
Transition relief permitting corrections of certain document failures without
current income inclusion or additional taxes under § 409A, if the document failure
is corrected by December 31, 2010, and any operational failures resulting from
the document failure are also corrected in accordance with Notice 2008-113,
2008-51 IRB 1305, by December 31, 2010.
This notice also clarifies certain aspects of Notice 2008-113, which addresses
certain failures of non-qualified deferred compensation plans to comply with § 409A in
operation (operational failures), including clarification of:
The application of the subsequent year correction method to late payments of
amounts deferred.
The calculation of the amount that must be paid to the service provider as a
correction of a late payment of an amount deferred under a plan if the payment
would have been made in property, such as shares of stock.
The calculation of the amount that must be repaid by the service provider as a
correction of an early payment of an amount deferred under a plan if the early
payment was made in property, such as shares of stock.
Source
IRS
Pinheiro says employers have another incentive to clean up any Section 409A documentation failures this year: to avoid an audit. “The IRS has announced that it plans to look closely at payroll tax issues and will audit up to 6,000 companies in 2010,” he says. “409A is the next logical step.”
As Compliance Week has previously reported, the IRS last fall sent Information Document Requests (a formal notice for paperwork and data) to some businesses already under audit, asking for details about pay practices that may be subject to Section 409A.
Hogans agrees. “The compliance or non-compliance you have now is very likely to matter in the future,” he says. “This is an area where IRS may find it relatively easy to collect revenue.”
And Berg warns that with the documentation and operational correction programs in place, “There won’t be an excuse not to fix any errors.”
Moreover, considering the public’s current anti-executive mood and the attention being paid to executive compensation issues, Pinheiro and others say highly paid executives and directors (who typically get their biggest payouts via deferred-compensation plans) aren’t likely to get much leniency from the IRS.
“409A is a real hammer, and there are real penalties associated with it,” Pinheiro says. “I fully expect to see 409A audits in the next five years.”
Corporations will have to meet a few hurdles to avail themselves of the Section 409A relief. For example, the guidance requires employers to correct all plans that have substantially similar document failures. In other words, if a company sponsors more than one deferred-compensation plan, all plans must be fixed for the same error, Cohen says.
That might be difficult for a large organization with multiple plans and many employees, says Hogans. “Just identifying all of the affected individuals to do the reporting can be difficult,” he says.
Both the employer and the employee must disclose notice of the correction on their federal income tax returns. Cohen also notes that the corrections are available only for inadvertent failures, and are restricted if the taxpayer or the employer is under IRS audit.
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