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Guest Article

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(From the January 11, 2010 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Notice 2010-6: Section 409A Document Failure Correction Program


Introduction

On January 5, 2010, the Internal Revenue Service (the "IRS") issued Notice 2010-6 which provides methods for taxpayers to voluntarily correct certain types of failures to comply with the document requirements of § 409A. This correction program is intended to encourage taxpayers to review nonqualified deferred compensation plan for § 409A document failures. The notice addresses eligibility, and provides methods for correcting plan provisions that do not comply with § 409A(a) plan document requirements. In some cases, plans may be corrected without service providers having to include amounts in income under § 409A, while in other cases as much as 50% of the amount deferred under the plan must be included in income, subject to the 20% additional income tax rate (although not the additional premium interest tax). In addition, taxpayers taking advantage of the correction program are generally required to attach a statement to their tax returns. Correction under the notice isolates the document failure to the year of correction, so that the document failure will not taint prior years.

Notice 2010-6 also modifies Notice 2008-113 (providing relief for certain operational failures to comply with § 409A) and Notice 2008-115 (providing guidance regarding § 409A reporting and withholding requirements for 2008 and subsequent years).

Effective Date

Taxpayers may rely on Notice 2010-6 for taxable years beginning on or after January 1, 2009. The modifications to Notice 2008-113 are effective for service provider taxable years beginning on or after January 1, 2010, but may be relied upon for service provider taxable years beginning before this date.

In particular, if a plan is eligible for correction under this notice, and the plan is corrected on or before December 31, 2010, the plan may be treated as having been corrected on January 1, 2009, and any income inclusion that would otherwise be required is waived, provided that any payment made before December 31, 2010 that would not have been made under the amended provision (or any payment not made before December 31, 2010 that would have been made under the amended provision) is treated as an operational failure and fully corrected in compliance with all the requirements of Notice 2008-113 on or before December 31, 2010.

The modifications to Notice 2008-115 are generally effective for service provider taxable years beginning on or after January 1, 2009, provided that the modifications to Notice 2008-115 that are due to changes to Notice 2008-113 are effective for service provider taxable years beginning on or after January 1, 2010 but may be relied upon for service provider taxable years beginning before that date.

The Treasury Department and the IRS are requesting comments regarding other document failures that commonly occur and methods to correct them. Comments must be submitted by April 5, 2010.

General Requirements

In order to be eligible for relief under Notice 2010-6, the taxpayer must satisfy general eligibility requirements (other than with respect to certain ambiguous terms, as discussed below), requirements for a particular correction method, and information and reporting requirements of the notice. The taxpayer has the burden of demonstrating eligibility for relief and that each of the requirements of the notice has been satisfied. A taxpayer's eligibility for relief is subject to examination by the IRS.

If a service recipient has identified and corrected a document failure in a nonqualified deferred compensation plan, the service recipient must take commercially reasonable steps to (i) identify all other nonqualified deferred compensation plans that have a document failure that is substantially similar to the one initially identified and corrected, even if the affected service provider does not participate in the other plan, and (ii) correct all failures consistent with Notice 2010-6. The plan aggregation rules do not apply to the written plan requirements. As a result, these rules do not apply to require correction of document failures under similar plans, unless the plan has a similar document failure.

Relief is not available to service providers and service recipients that are under examination before correction is complete. An individual service provider or service recipient is treated as under examination with respect to nonqualified deferred compensation if the individual's federal income tax return is under examination (for example, Form 1040). A non-individual service provider or service recipient is treated as under examination if the service provider or service recipient receives written notification (for example, by examination plan, information document requires, or notification proposed adjustments or income tax examination changes) from an examining agent specifically citing nonqualified deferred compensation as an issue under consideration. For corrections prior to December 31, 2011, a non-individual service recipient will be treated as "under examination" only if the specific document failure has been identified on examination.

Relief is not available for intentional failures or failures that are directly or indirectly related to participation in any listed transaction under Treas. Reg. §1.6011-4(b)(2).

In addition to the general requirements, the notice addresses issues such as coordination of multiple failures and how to measure the amount of income to be included, to the extent required.

Eligible Document Failures

If the taxpayer meets all of the eligibility requirements, the following corrections are available for the specified document failure:

  1. Ambiguous Plan Terms. These are terms that are undefined or have an ambiguous definition relative to the requirements of § 409A. If plan operation is consistent with § 409A, no amendment is required, although a taxpayer may nevertheless decide to amend these provisions to eliminate the ambiguity. On the other hand, if the facts and circumstances indicate that a service recipient has intentionally used the ambiguous term to pay amounts, the plan and any other plan of the service recipient with the same or substantially similar language (regardless if the plans include any of the same service providers) will not be eligible for relief.

    • "As Soon As Reasonably Practicable": An ambiguous plan term includes a provision for payment to be made "as soon as reasonably practicable" upon a section 409A permissible payment event, or provides similar timing language. If a plan includes this language and payments are made in compliance with section 409A (i.e., no later than the end of the service provider's taxable year in which the event occurs or the 15th day of the third month following the month the event occurs), the provision would not fail to satisfy § 409A(a) requirements. If the payment is made after this period, the failure is as an operational failure, unless the service provider can demonstrate that the delay qualifies for a timeliness exception (for example, payment would have jeopardized the ability of the service recipient to continue as a going concern).
    • Ambiguous Payment Event Definitions: An ambiguous plan term also includes a plan provision that designates a payment event but does not define the event or has an ambiguous definition of the event relative to compliance with § 409A. Note that if the plan includes language that terms are to be interpreted in a manner consistent with § 409A, the term is not considered ambiguous.
    • An ambiguous payment event will not cause a plan to fail to satisfy § 409A(a). If a payment is made that does not comply with § 409A, this may be treated as an operational failure eligible for relief under Notice 2008-113, provided the plan is amended before the end of the service provider's taxable year during which the operational failure is corrected in accordance with Notice 2008-113. The amendment may either add language to require the provision be interpreted in accordance with § 409A(a) or set forth definitions that comply with § 409A. The amendment may not expand the definition to add or eliminate payment events that were not available before the amendment.
    • This relief is not available if (i) the provision has been interpreted by the service recipient, on or after January 1, 2009, through its pattern or practice of administering the plan, or (ii) a court with jurisdiction over enforcement of the contract has interpreted the provision. Instead, the term is then considered one providing for an impermissible payment event (see below).
  2. Impermissible Definition of Otherwise Permissible Payment Event: Plan provisions that provide for payment upon separation from service, change in control, or disability based on definitions that do not comply with § 409A may be eligible for relief if the plan is amended before the date the event occurs. The amendments must be effective immediately. In general, the amendment cannot provide for payment events that were not available before the correction, however, relief to correct payments on disability allows the payment event to be removed entirely.

    In the case of payments upon separation from service or change in control, the correction may be done without income inclusion if an event that would have been a payment under the preamendment plan but not the corrected plan does not occur within one year following the date of correction. If such an event does occur within one year following the date of correction, then in the taxable year the event occurs, the service provider must include in income, and the service recipient must report, an amount equal to 50% or 25% of the amount deferred in the case of separation from service and change in control, respectively. These amounts are subject to the 20% additional income tax, but not the premium interest tax. If the plan provision is not corrected before the event occurs, the plan would fail to satisfy § 409A for the year of the event and all previous years in which the plan continued the plan provision.

    There is a special rule for payments upon disability if the provision is corrected after the event. In this case, the plan may be corrected retroactively if any amount paid on an event that would not qualify as a disability under § 409A is corrected as an operational failure under Notice 2008-113.

  3. Impermissible Payment Period Following a Permissible Payment Event: A plan that provides for a § 409A compliant payment event but provides for payment more than 90 days following the event or allows the service provider to choose the taxable year of payment may be corrected by amending the plan to either remove the payment period or set forth a compliant payment period. If the plan is not amended before the event but is amended a reasonable time after the event occurs, the plan would be treated as failing to comply with § 409A(a) and the affected service provider must include in income 50% of the amount deferred under the plan in the taxable year of the service provider within which the permissible payment event occurred, with such amount subject to the 20% additional income tax..

    Relief is also available for payments upon permissible events that are conditioned upon employment-related actions of the service provider, such as execution and submission of a noncompetition or nonsolicitation agreement, or a release of claims. The plan must be amended before the event occurs to (i) remove the provision, (ii) provide that payments will be made on the last day of the payment period if a period is designated, or (iii) if a period is not designated, provide that payments will be made either 60 or 90 days following the event. The amendment may not otherwise change the time or form of payment. If the provision is not corrected before the event, the affected service provider would be subject to § 409A income inclusion, 20% penalty and premium interest tax.

  4. Impermissible Payment Events and Payment Schedules: Notice 2010-6 provides relief for plans that provide for payment upon permissible and impermissible payment events, plans that have only impermissible events, certain impermissible alternative schedules, and impermissible reimbursement or in-kind benefit provisions. Relief is also available for provisions that provide service recipients and service providers with impermissible discretion to change a payment schedule or make subsequent deferral elections, and provisions that provide service recipients discretion to accelerate payments. These failures may be corrected before the event occurs by an amendment that is immediately effective. In some cases, if an event that would have been a payment event under the terms of the pre-amendment plan, but not under the plan as corrected, occurs within one year of the date of the correction, the service provider must include 50% of the deferred amount in income in the taxable year of the service provider within which the payment event occurred, subject to the 20% additional income tax.
  5. Failure to Include the 6-Month Delay: If a plan fails to include a provision that provides for the six-month delay for payments upon separation from service to specified employees, relief is available if the plan is amended before the event occurs. The amendment must add the six-month delay and provide that payments subject to the delay will not be paid before the later of (i) 18 months following the date of correction, or (ii) six months following the date of the payment event. If these requirements are satisfied, the amendment will not be treated as a subsequent change in time or form of payment. If an employee has a separation of service within one year of the date of correction and the provisions of the corrected plan result in a deferral relative to the pre-amendment plan, the service provider must include in income 50% of the amount deferred under the plan in the service provider's taxable year within which the separation from service occurs, subject to the additional 20% income tax.
  6. Impermissible Deferral Elections: Relief is available for initial deferral elections that do not comply with § 409A(a). This relief does not apply to elections as to time and form of payment since relief for certain of these failures is available in other sections of Notice 2010-6. If a noncompliant initial deferral election is revoked prior to the § 409A deadline for making an initial deferral election, the service provider is not required to include amounts in income under § 409A. The plan must be corrected no later than the end of the service provider's second taxable year immediately following the taxable year during which the applicable deadline for making an initial deferral election under § 409A expires. Amounts subject to the noncompliant deferral elections must be corrected in accordance with Notice 2008-113, which may require income inclusion under § 409A. The relief for this correction does not have retroactive effect on amounts deferred in previous years that are subject to noncompliant deferral elections. As a result, the plan document failure remains for previous years and any resulting deferral will remain an operational failure. The service recipient must take commercially reasonable steps to identify and correct similar provisions in all of its plans.
  7. Amendment Period Following a Service Recipient's Initial Adoption of a Plan: Notice 2010-6 provides relief for certain new plans that have a document failure within the first year the legally binding right to deferred compensation was established. A plan provision is eligible for relief under the notice if the plan is amended, and any payments are treated as operational failures and corrected under Notice 2008-113 by the end of the calendar year in which the document failure is corrected. The plan must be amended by the later of the end of the calendar year in which, or the 15th day of the third calendar month following the date, the first legally binding right to deferred compensation arose under the plan and all other plans that may be aggregated with the plan if a single service provider participated in all of the plans. For these purposes, the provisions of Notice 2010-6 will be applied without applying the requirement of income inclusion if an event occurs within one year of the date of correction.

Stock Rights and Linked Nonqualified Plans

Notice 2010-6 does not provide relief for stock rights or plans where the time and form of payment under a nonqualified deferred compensation plan is linked to one or more other nonqualified deferred compensation plans or one or more qualified plans. Certain relief for discounted stock rights is set forth in Notice 2008-113. The notice provides transition relief for corrections made on or before December 31, 2011 with respect to linked nonqualified deferred compensation plans and payment schedules determined by the timing of payments received by the service recipient. Generally, if any amounts have been paid under the plans pursuant to the pre-amendment provisions since January 1, 2009 or inconsistent with the amended provisions, these amounts must be treated as operational failures and corrected under Notice 2008-113.

Changes to Notice 2008-113 and Notice 2008-115

The notice also modifies several provisions of Notices 2008-113 and 115. In particular, the modifications clarify treatment of correction of distributions involving transfers of stock or other property and coordination of repayment with adjustments to withholding.

  1. Notice 2008-113: This notice is modified to provide that if relief requires a service provider to repay amounts, the service provider may repay the net amount received after any withholding to the extent the service recipient has made a correction (such as an adjustment made on a Form 941-X) to recover the amount of taxes withheld on the amount erroneously withheld. In lieu of repayment, the service recipient may reduce other compensation due to the service provider, provided the other compensation is included in income. An amount is not treated as repaid if in connection with repayment the service recipient pays or provides the service provider a benefit intended to substitute the repaid amounts.

    Notice 2008-113 has been modified to address how to determine the repayment amounts in the event of an operational failure involving amounts that were erroneously paid or deferred in the form of property (such as stock). The amount that must be repaid equals fair market value of the property at the time of the erroneous payment. Any difference between the fair market value at the time of the erroneous payment and the time of repayment is treated as earnings or losses in accordance with the applicable section of Notice 2008-113. If the amount erroneously deferred was set as a dollar amount, the deferral equals the dollar amount. If the amount of the erroneous deferral was based on certain property, the amount of the deferral equals the fair market value of the property at the time it would have otherwise been payable had the deferral not occurred. Relief for operational failures involving excess deferrals corrected in the tax year following the year of the failure have been changed to include failure to pay amounts during the year in which the original payment date occurred.

  2. Notice 2008-115: If a taxpayer is entitled to relief under Notice 2010-6, Notice 2008-115 is modified to conform to the provisions of Notice 2010-6, including modifications to Notice 2008-113, with respect to the amount required to be include in income by a service provided under § 409A and the amount of § 409A income that is required to be reported by a service provider.

Conclusion

In general, Notice 2010-6 provides significant relief with respect to potential document failures, in allowing correction in one year to address failures in prior years. This notice and Notice 2008-113 give taxpayers many opportunities to address noncompliance in advance of an IRS examination. Audit activity related to § 409A has commenced and individuals with noncompliant compensation are sometimes receiving notices. Thus, it is important for all taxpayers to review their arrangements to uncover any noncompliance.

While the notice provides welcome relief, it does require significant income inclusion in some cases based on post-amendment events, which may affect service providers with similar issues differently for reasons outside the control of the service provider. Similarly, the notice imposes requirements on the service recipient, such as consistency in corrections that are outside the control of the service provider. Treasury and the IRS have requested comments, which can be expected to address these issues among others.


Deloitte logoThe 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, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955.

Copyright 2010, Deloitte.


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