Guest Article

(From the December 8, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Provides Limited Relief for Certain Section 409A Operational Failures

On December 5, 2007, the IRS issued Notice 2007-100, providing relief for certain section 409A operational failures, and requesting comments on correction under section 409A. On December 5, 2008, Notice 2008-113 was issued. Notice 2008-113 updates and, for periods beginning on or after January 1, 2009, replaces Notice 2007-100.

Notice 2008-113 addresses the correction of operational errors that are made during the same tax year as the failure occurs and correction of certain operational failures. The relief is in addition to any other action that would otherwise be permissible under generally applicable tax principles and any adjustments or corrections that may be available under current transition relief, which is generally scheduled to expire on December 31, 2008.

Basic Requirements for Notice 2008-113 Reliance

Notice 2008-113 applies only inadvertent and unintentional failures in operation of a plan that otherwise complies with section 409A. In addition, the service recipient must take commercially reasonable steps to avoid recurrence of the failure. In particular, if the same or a substantially similar failure has happened before, relief is available for taxable years beginning after December 31, 2009, only if the service recipient can demonstrate that it had taken steps to ensure that the failure would not recur, and that the failure occurred despite such efforts. In addition, in order to correct a failure in a year after the year in which the failure occurred, the service provider must not be under examination with respect to the plan. Certain corrections are not available during years in which the service recipient experiences a substantial financial downturn or there is other indication of a significant risk that the service recipient would not be able to pay the amount deferred when due.

In some cases, the ability to correct depends on whether the service provider is an "insider," not a director, officer, or 10% owner of a corporation, or analogous persons for non-corporate service recipients.

Notice 2008-113 generally requires service recipients who rely on it to attach a statement to their tax return explaining their reliance and to provide information to affected service providers (other than with respect to correcting discounted options and stock appreciation rights). Service providers are required to attach this information to their original federal income tax return.

Available Correction Methods

If all of the foregoing eligibility requirements are met, the following corrections are available with respect to operational failures. The extent to which correction is available depends on the timing of the correction, the status of the service provider as an insider, and the amount involved.

Early Payments and Failed Deferrals

Definition of "Early Payments." Early payments are defined as amounts deferred in a prior year that should be paid in a future year, but are mistakenly paid or made available during the current year. Early payments do not include payments that fail to comply with the 6-month delay rule for specified employees or current year amounts that should have been deferred, but were paid currently.

Correction in the Same Taxable Year. With respect to early payments that are identified in the same year paid, Notice 2008-113 allows early payments to be repaid by the end of the service provider's taxable year for distribution as otherwise provided by the deferred compensation arrangement. This can be done through actual repayment or through the service recipient's retention of other amounts payable, provided that these amounts are included in income. In addition, Notice 2008-113 allows the repayment to be completed over a grace period of up to 24 months from the due date (without extension) for the federal income tax return for the year in which the error occurred, if the amounts were made available to a non-insider and repayment would result in an immediate and heavy financial need for the service provider (within the meaning of the 401(k) regulations). Repayments over the grace period must include interest at a rate no lower than the short-term applicable federal rate (AFR) and must be subject to a legally binding agreement between the service provider and the service recipient for the repayment plan. Interest is required in all events if the total repayment for a year exceeds the section 402(g) deferral limit ($15,500 in 2008) and the service provider is an insider.

The service recipient's account balance or benefit may be adjusted for losses. The adjustment generally must be made by the end of the service provider's tax year.

The amount mistakenly paid or made available to the service provider is not required to be reported on Form W-2 or Form 1099. If the correction is through actual repayment, the employer should adjust the federal employment and income taxes withheld and paid in accordance with section 6413. If repayment is accomplished by withholding amounts from future wages, the amounts withheld will not be subject to federal employment and income taxes and no adjustment should be made to the federal employment and income taxes withheld and paid on the failure amount. The net result is that all amounts otherwise payable in income for the year are included in wages and income, but the inadvertent payment is not. The service recipient cannot reimburse the service provider for the repayment or provide benefits as a substitute for it.

In the case of a non-insider, correction of certain operational failures may be made in the year immediately following the year in which the failure occurred. Correction in the subsequent year is permitted regardless of whether a substantially similar failure was made with respect to both an insider and a non-insider service provider, but correction is only permitted for the non-insider.

Correction in the Taxable Year after the Year of Failure. With respect to non-insiders, early payments can be repaid to the service recipient and treated as having been timely deferred or continuing to be deferred by the end of the service provider's taxable year after the year in which the failure occurred. If the year after the year of failure is the correct year of payment, the service provider is required only to make a payment of interest (at the short-term AFR) is necessary for correction.

As with provisions for correction in the same year, a 24-month grace period is available if repayment would result in an immediate and heavy financial need for the service provider.

There may be an adjustment to account for earnings or losses on restoration of the amount under the plan, provided it is made by the end of the year in which repayment is made.

In this case, the amount mistakenly paid or made available to the service provider is required to be included in income and reported on Form W-2 or Form 1099 for the year in which the erroneous payment was made. The service provider is permitted to claim a deduction in determining adjusted gross income in the year of correction. If the repayment is accomplished through withholding other wages, the reduction must be net of taxes. In this case, a deduction for the repayment is still permitted. Finally, the distribution later made from the plan will also be included in income and reported on Form W-2 or Form 1099.

Failure to Delay Distribution of Deferred Compensation

Definition of Failure to Delay Distributions. A failure to delay a distribution is defined as a payment made more than 30 days prior to the distribution date as otherwise defined under the plan or payment of an amount to a specified employee within six months after separation from service.

Correction in the Same Taxable Year. The service provider is required to repay the early distribution, subject to an agreement that the service recipient will make the distribution as provided. If repayment is made prior to the date on which payment should have been made, the service provider must wait additional time after the correct payment date equal to the number of days he held the erroneous payment. If repayment is made subsequent to the date on which payment should have been made, the service provider must wait additional time after the original payment date equal to the number of days he held the erroneous payment plus the original waiting period under the plan or applicable guidance.

In either case, the service provider's account may be adjusted for losses, provided the adjustment is made on or before the applicable deadline for repayment. An adjustment for earnings may not be made.

Reporting and withholding rules similar to those for correcting early payments apply. Thus, the amount mistakenly paid or made available to the service provider is not required to be reported on Form W-2 or Form 1099. In addition, the employer should adjust the federal employment and income taxes withheld and paid in accordance with section 6413. If repayment is through withholding amounts from future wages, the amounts withheld will not be subject to federal employment and income taxes and no adjustment should be made to the federal employment and income taxes withheld and paid on the failure amount. The net result is that all amounts otherwise payable in income for the year are included in wages and income, but the inadvertent payment is not. Here again, the service recipient cannot reimburse the service provider for the repayment or provide benefits as a substitute for it.

Correction in the Taxable Year after the Year of Failure. If a failure to delay relates to a payment to a non-insider, it may be corrected by repaying the entire amount by the end of the year immediately following the year in which the failure occurred. After the repayment, the service provider must have a legally binding right to receive such amount on a date after the date of the repayment equal to the amount of days between the date the erroneous payment was made and the date the erroneous payment should have been made.

In this case, the amount of the erroneous payment is included in income, with a deduction allowed for the amount of the repayment if the repayment and the subsequent payment do not fall within the same taxable year of the service provider. To the extent the repayment and subsequent payment are made within the same taxable year of the service provider, the subsequent payment need not be included in the income of the service provider.

The service provider's account may not be adjusted for earnings, but may be adjusted for losses, retroactive to the date on which the erroneous payment was made, provided such adjustment is made prior to the deadline for the repayment.

Excess Deferrals

Definition of Excess Deferrals. Excess deferrals are deferral in excess of the amount provided for under the plan or election.

Correction in the Same Taxable Year. The excess amount deferred must be distributed by the end of the service provider's current taxable year, with an adjustment made to the amount to which the service provider has a legally binding right at the end of the year (e.g., a reduction in his account balance).

If the service provider is an insider (as defined above), the account balance or benefit must be adjusted for any positive earnings attributable to the mistaken deferral. In all other cases, an adjustment for earnings or losses is optional. In any case, adjustment generally must be made by the end of the service provider's taxable year. The service recipient may not otherwise pay interest to the service provider for the time value of money.

The amount paid must be included in income and subject to appropriate employment tax withholding, but no other specific reporting or withholding correction is applicable.

Correction in the Taxable Year after the Year of Failure. Excess deferrals by a non-insider are permitted to be corrected through a distribution of the excess deferral by the end of the year immediately following the year in which the failure occurred. There must be a related adjustment to the amount to which the service provider has a legally binding right at the end of the year (e.g., a reduction in his account balance). A payment of interest to the service provider representing the lost time value of money is not permitted. After the distribution is made, the account may be adjusted for earnings or losses, retroactive to the date the excess amount was incorrectly credited to the service provider's account, but only if the adjustment is made by the end of the year in which the erroneous deferral was made.

The amount paid must be included in income and subject to appropriate employment tax withholding, but no other specific reporting or withholding correction is applicable.

Discounted Stock Options and Stock Appreciation Rights

Definition of Discounted Stock Option and Stock Appreciation Rights. A stock option or stock appreciation right (stock right) that constitutes nonqualified deferred compensation solely because the exercise price was erroneously set at an amount less than the fair market value of the underlying stock on the date of grant, is a discounted stock right eligible for correction.

Correction in the Same Taxable Year. During the year of grant, the exercise price may be reset to an amount not less than the fair market value on the date of grant prior to the date of exercise or the last day of the service provider's taxable year in which the grant was made. Correction can be made to outstanding stock rights even if other rights in the same grant were already exercised and therefore ineligible for correction. Notice 2008-113 provides no correction method for discounted options after exercise.

Correction in the Taxable Year after the Year of Failure. For grants made to non-insiders, the exercise price of a discounted stock right is permitted to be reset to an amount not less than the fair market value on the date of grant, if the reset occurs prior to the earlier of the exercise date or the end of the service provider's year immediately following the year in which the stock right was granted.

Relief for Failures Involving Limited Amounts

In addition to the correction methods discussed above, Notice 2008-113 provides relief from the taxes that would be incurred with respect failures involving limited amounts. This relief is available only to the extent that all steps are taken by the end of the second taxable year after the taxable year of the service provider in which the failure occurred.

Early Payment, Failed Deferrals, and Failures to Delay Distributions

With respect to failures involving early payments, failed deferrals, or failure to delay distributions if the total, aggregate amount involved for a year is less than the section 402(g) deferral limit ($15,500 in 2008) for that year, and all of the other requirements of Notice 2008-113 are met, taxation of early payments and failed deferrals is limited to ordinary income taxes and the 20% additional tax imposed on the amount of the failure and does not require the payment of the additional premium interest tax.

The amount involved is determined taking into account all arrangements are treated as a single plan under section 1.409A-1(c).

The service recipient must report the amount of the early payment or failed deferral on Form W-2 or Form 1099. If the service provider is an employee of the service recipient, then this amount should be reported in Box 12 using Code Z.

Excess Deferrals

If the excess deferral for a year is less than the section 402(g) deferral limit, and all of the other requirements are met, taxation of the excess deferral is limited to ordinary income taxes and the 20% additional tax on the amount of the failure.

The service recipient must report the amount of the early payment or failed deferral on Form W-2 or Form 1099. If the service provider is an employee of the service recipient, then this amount should be reported in Box 12 using Code Z.

Earnings associated with the corrective distribution must be forfeited or included in the payment to the service provider. Losses through the date of payment must be permanently disregarded or subtracted from the payment.

Relief for Certain Other Operational Failures

Notice 2008-113 provides further relief in some circumstances in which correction is made by the end of the second taxable year after the taxable year in which the failure occurs by limiting the extent to which the premium interest tax is applicable.

Early Payments and Failed Deferrals

Early payments or failed deferrals, but not a failure to delay a distribution for the 6-month delay requirement for specified employees, can be corrected by the end of the service provider's second taxable year following the year of the failure. Correction requires repayment of the erroneous payment, income inclusion of the repayment amount, and payment of the 20% additional tax on the amount of the repayment. Under this correction method, the service provider is not required to pay the premium interest tax.

The service recipient must report the amount of the failed deferral on Form W-2 (or Form W-2c), under Box 12, Code Z, or Form 1099 (or corrected Form 1099) in the year that the failure occurred. The service provider must include in income and pay the additional taxes on his original or amended federal return for the year in which the erroneous payment was made.

The service provider's account may be adjusted for earnings or losses, retroactive to the date the deferral should have been made, provided the adjustment is made by the applicable deadline for repayment. If the service provider is an insider, the repayment must include interest at not less than the short-term AFR, compounded annually.

Failure to Delay Distributions

Failures to delay distributions, including payments that are paid in the correct year, but are paid more than 30 days early, and payments that fail the 6-month delay requirement for specified employees may be corrected through repayment of the erroneous payment by the end of the second taxable year after the year in which the failure occurred. Correction will also include income inclusion of the repayment amount and the 20% additional tax. Under this correction method, the service provider is not required to pay the premium interest tax.

Immediately after such repayment, the service provider must have a legally binding right to receive the amount otherwise payable under the plan on a date after the repayment that is equal to the amount of days between the date the erroneous payment was made and the date the erroneous payment should have been made.

The service recipient must report the amount of the failed deferral on Form W-2 (or Form W-2c), under Box 12, Code Z, or Form 1099 (or corrected Form 1099) in the year that the failure occurred. The service provider must include in income and pay the additional taxes on his original or amended federal return for the year in which the erroneous payment was made.

The service provider's account may not be adjusted for earnings, but may be adjusted for losses, retroactive to the date the deferral was erroneously paid, provided the adjustment is made by the applicable deadline for repayment.

Excess Deferrals

Excess deferrals can be corrected through inclusion in income no later than the end of the second taxable year after the year of the failure, and at that point the service provider is required to pay the 20% tax, but not the premium interest tax. The distribution is treated as previously included in income, for purposes of section 409A(c), in taxable years after the year of the failure.

The distribution must be made by the second taxable year following the taxable year during which the failure occurred. The service recipient must report the amount of the failed deferral on Form W-2 (or Form W-2c), under Box 12, Code Z, or Form 1099 (or corrected Form 1099) in the year that the failure occurred. Reporting pursuant to the requirements of this correction method will exempt the service recipient from penalties and liabilities associated with the failure to properly withhold under section 3402(d).

The service provider must include in income and pay the additional taxes on his original or amended federal return for the year in which the error occurred. The remaining account balance must be adjusted for earnings, and may be retroactively adjusted for losses, provided that any adjustment must be made before the last day of the year in which the corrective distribution was made.

Request for Comments

Notice 2008-113 also includes a request for comments related to a potential correction program for plan document failures.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.