Guest Article

(From the December 10, 2007 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. Notice 2007-100 addresses correction of operational errors that are made during the same tax year and correction of certain de minimis operational failures in the year following the year of the failure. Exercise of a stock right that results in a failure under section 409A is specifically excluded from correction. The relief is in addition to adjustments or corrections that may be available under current transition relief, which is generally scheduled to expire on December 31, 2008, as well as any other action that would otherwise be permissible under generally applicable tax principles. In addition, Notice 2007-100 includes an extensive request for comments on a potential corrections program. Thus, while Notice 2007-100 may be helpful to some taxpayers under limited circumstances during the transition period, its greater significance is as a first step toward a post-transition-relief corrections program.

Basic Requirements for Notice 2007-100 Reliance

Notice 2007-100 can be relied upon only if certain basic eligibility requirements are met. The failure must be an unintentional failure to comply with plan provisions that comply with section 409A, or to follow section 409A in practice, due to inadvertent errors in plan operation. The failure cannot be egregious or related to participation in a listed transaction under Treasury Regulation § 1.6011-4(b)(2). The service recipient must take commercially reasonable steps to avoid recurrence of the failure. If the same or a substantially similar failure has happened before, then relief is available for taxable years beginning after December 31, 2008, only if the service recipient has established practices and procedures reasonably designed to ensure that the failure would not recur and taken commercially reasonable steps to avoid recurrence, but the failure occurs despite the service recipient's diligent efforts. In addition, for de minimis corrections, the taxpayer must not be under examination with respect to the plan.

Taxpayers who rely on Notice 2007-100 have the burden of showing that they satisfy its requirements, and the application of Notice 2007-100 is subject to IRS examination. Toward these ends, Notice 2007-100 generally requires service recipients who rely on it to attach a statement to their tax return explaining their reliance and to notify the examining agent of their reliance upon commencement of an examination. In addition, they must provide the affected service providers with a statement that, in some cases, must be filed with their tax returns. For details, see section IV of Notice 2007-100. Finally, certain corrections are not avail able during taxable years in which the service recipient experiences a substantial financial downturn or other indication of a significant risk that the service recipient would not be able to pay the amount deferred when due.

Methods for Correcting Failures within the Service Provider's Taxable Year

If all of the foregoing eligibility requirements are met, then the service provider may be able to correct certain unintentional operational failures during the taxable year of the service provider in which they occur. The allowable correction method depends on the type of failure:

Early Payments and Failed Deferrals

In general, early payments (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) and failed deferrals (amounts otherwise payable in the current year that should have been deferred to a future year but are mistakenly paid or made available during the current year) can be repaid to the service recipient and treated as having been timely deferred or continuing to be deferred. Repayment can occur by actual payment or by withholding from future payments, so long as it is completed by the end of the service provider's taxable year.

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 (a director, officer, or 10% owner of a corporation, or analogous persons for non-corporate service recipients), then the amount must be repaid with interest calculated at the annual short-term AFR.

The service recipient's account balance or benefit may be adjusted for earnings or losses. The adjustment generally must be made by the end of the service provider's tax year, but if that is impracticable and the service provider and service recipient each has a legally binding right with respect to the adjustment as of that date, it may be made later, retroactive to that date.

The amount mistakenly paid or made available to the service provider is not required to be reported on Form W-2 or Form 1099. Thus, if the service provider is an employee and repayment is accomplished by actual payment from the employee to the employer, then the employer should adjust the federal employment and income taxes withheld and paid in accordance with section 6413. However if repayment is accomplished by withholding amounts from future wages, then 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 pay able in income for the year are included in wages and income, but the inadvertent payment is not. Of course, the service recipient cannot reimburse the service provider for the repayment or provide benefits as a substitute for it.

Failure to Delay Distribution of Deferred Compensation on Separation from Service

Special rules apply to amounts mistakenly paid or made available to specified employees within six months after separation from service. The service provider not only must repay the amount, but also must wait additional time -- equal to the number of days he held the mistaken payment -- after the original six-month period expires before he can receive payment. Notice 2007-100 seems to require actual repayment rather than withholding from other payments. Thus, if the service provider is an employee, then the employer should adjust the federal employment and income taxes withheld and paid in accordance with section 6413 and will be required to withhold and pay them when the amount is again paid or made available. Section 404(a)(5) and the service recipient's method of accounting will determine the proper year of the service recipient's deduction.

Excess Deferrals

Notice 2007-100 also provides a specific correction related to a mistake in retaining amounts that were not subject to a deferral election if the amounts are distributed by the end of the service provider's current taxable year. This rule does not apply to amounts deferred in the service provider's prior tax years.

If the service provider is an insider (as defined above), then in order to rely on the Notice 2007- 00 correction method, his 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, any adjustment generally must be made by the end of the service provider's taxable year, but if that is impracticable and the service provider and service recipient each has a legally binding right with respect to the adjustment as of that date, it may be made later, retroactive to that date. The service recipient may pay reasonable interest to the service provider for the use of his money, so long as it is paid or made available by the end of the service provider's taxable year.

Discounted Stock Options and Stock Appreciation Rights

If a stock option or stock appreciation right is nonqualified deferred compensation solely because the exercise price was less than the fair market value of the underlying stock on the date of grant due to an unintentional administrative error in determining the exercise price, and the exercise price is reset before the stock right is exercised, then the stock right will be treated as not providing for nonqualified deferred compensation. This determination is made on a share-byshare basis. Therefore, if a service provider exercises an option with respect to only a portion of the shares subject to the option, the remainder of the shares is eligible for correction, even though the exercised shares are not. As noted above, Notice 2007-100 provides no correction method for pre-correction exercises.

Methods for Limiting Taxes After the Service Provider's Taxable Year

If an unintentional operational failure is not corrected by the end of the service provider's taxable year in which it occurs, Notice 2007-100 does not allow the service provider to avoid tax under section 409A(a) by correcting the failure; however, if certain requirements are met, the amount of tax the service provider owes may be limited. In addition to the basic requirements for Notice 2007-100 reliance discussed at the beginning of this article, the failure must occur in a taxable year beginning before January 1, 2010, taxation must occur before the end of the second taxable year of the service provider following the year of the failure, the total amount of operational failures under all arrangements treated as a single plan of the service provider under Treasury Regulation § 1.409A-1(c) cannot exceed the section 402(g) deferral limit for the year ($15,500 for 2008), the service provider's income tax return for the year of the failure must not be under IRS examination, and the failure that is being corrected must be the plan's only section 409A violation.

Early Payments and Failed Deferrals

If all of the foregoing requirements are met, then taxation of early payments and failed deferrals is limited to ordinary income taxes and the 20% additional tax under section 409A(a)(1)(B)(i)(II) on the amount of the failure. Other amounts deferred under the plan are not currently taxed, and the premium interest tax under section 409A(a)(1)(B)(i)(I) does not apply. There are no special rules for specified employees.

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.

This relief is not available during taxable years in which the service recipient experiences a substantial financial downturn or other indication of a significant risk that the service recipient would not be able to pay the amount deferred when due.

Excess Deferrals

If an amount mistakenly was not paid or made available to the service provider, then the service recipient must pay the service provider that amount by the later of the service provider's taxable year in which the failure is discovered or the 15th day of the third month following discovery of the failure. Any earnings on that amount must be forfeited or paid to the service provider, and any losses must either be permanently disregarded or deducted from the payment. The amount of the payment must be reported on Form 1099 or Form W-2. If it is reported on Form W-2, it must be reported in Box 12 using Code Z. The service provider must file a timely income tax return including the failure amount in income and paying the additional 20% tax. For this purpose, an extended return is considered timely, but an amended return is not. If all of these requirements (and the applicable requirements above) are met, then the failure amount is not included in the service provider's income until it is actually paid or made available and the service recipient will not be subject to penalties or liabilities for failing to withhold properly.

Discounted Stock Options and Stock Appreciation Rights

This relief is not available for stock right exercises.

Potential Corrections Program

Notice 2007-100 requests comments on a potential corrections program that would closely resemble Notice 2001-100 in many respects. Possible changes could include making permanent Notice 2007-100's limited taxation of small operational failures, covering failures after the service provider's taxable year in which the failure occurred regardless of the size of the failure, adopting a basis-tracking approach for accelerated payments, and requiring excess deferrals to be reported as income in the year of failure (on an original or amended return) rather than in the year of correction.

Conclusion

Notice 2007-100 is more important for what it will become than what it is. Many practitioners believe there is sufficient authority to correct at least operational failures by the end of the service provider's taxable year without relying on Notice 2007-100 or complying with its specific requirements. Therefore, the key issues for the future will concern operational failures that are not corrected by the end of the service provider's taxable year. Those issues may not seem pressing now, given that the end of the transition period is still more than a year away. However, Notice 2007-100 is a reminder that planning is well underway at IRS and Treasury for a time when generous transition rules will be a thing of the past and gives taxpayers and practitioners the opportunity to help shape the rules for the future.

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, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.