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ERISA-Bubs

Will similar awards in different years be aggregated?

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We have some deferred compensation awards, subject to 409A, that were granted in 2016 and we've discovered they violate 409A.  The errors are such that they cannot be corrected, so several participant are in violation of 409A and subject to the 20% penalty.

Now we  have corrected the plan errors going forward and would like to award some of these participants similar awards for 2018.  If we do that, will the 2016 and 2018 awards be aggregated, such that if the 2016 awards violate 409A, so will the 2018 awards, and ALL that deferred comp is subject to the 20% penalty?

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But if the 2016 awards are not reported as violations of 409A, then would the 2018 awards be tainted.

I'm not suggesting breaking the law, I'm just wondering about this scenario:  2017 awards may violate 409A, but 2018 awards do not.  We are not totally sure the 2017 awards violated 409A (there is a decent argument they do not, but it's possible the IRS could disagree), so they were never reported as 409A failures.  Say the IRS does an audit in 2019, finds the 2017 awards violate 409A but the 2018 awards do not -- does the 20% penalty hit both awards because they are considered aggregated and the 409A violations were never addressed for the 2017 awards?

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Since you said you corrected the errors, presumably by recognizing the entire balance at the time to the additional income taxes, then prospectively the plan is fine.  Now if 2017 awards are found to violate 409A, but are not corrected until 2019, then the balance in 2019 (less what has already been recognized in income) is what's subject to the 409A additional income taxes.  In that sense, you can say the future awards are "aggregated". 

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Darn, so that means if 2017 is questionable, if we treat it as not a 409A failure, all future awards between now and the time the IRS disagrees with our 2017 analysis are subject to the 20%.

We might have to re-think whether it is worth it to argue the 2017 awards are compliant and maybe err on the side of reporting them as failures.

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So first, the statute itself is not self-evident on this, and we are only under proposed regs. The proposed regs (REG-148326-05, proposing Treas. reg. 1.409A-4), both in the preamble and the text of the proposed reg itself, state forthrightly, albeit generally, that a 409A violation in one year does not taint future years if the same violation does not occur in later years. The preamble even acknowledges that this may mean that the year of the error will become a closed year under the 3- or 6-year statute, depending on the amount involved, and says that while the amount would then escape 409A penalties, it would not escape regular income tax, because the "duty of consistency" would prohibit the taxpayer from claiming 409A basis  for the 409A inclusion he/she did not take into account within the period open under the statute.

There's not a lot of detail beyond the above, and neither the preamble nor the proposed regs themselves seem to make a clear distinction between operational errors and plan document errors. My own conclusion is that even plan document errors can be limited to the years before correction. Say, for example, you have a new plan in 2016 and participant P defers $10,000. Plan provides for payment only at separation from service, and everything is good with plan document and operation except plan says that plan says P can elect to receive 90% of his/her account balance at any time (so-called "haircut" provision, which I am using for example since it is uncorrectable under Notice 2010-6). Employer discovers error in January, 2017 and amends the plan to take away the haircut. P then defers $10,000 in each of 2018, 2019, etc.

It seems likely under the proposed regs that the amounts deferred in 2018, 2019, etc., and their attributable earnings, are not subject to 409A penalties based on the haircut that was in effect in 2016 and 2017. Some might argue that you have to "purge" the plan of the 2016 and 2017 money, e.g. by distributing it, but I don't think so, although I do think it is the case that the future earnings on the 2016 and 2017 money remain subject to 409A early inclusion in penalties, even if the employer Code Z's the 2016 and 2017 amounts. It's also not clear to me whether you can leave the haircut in for the 2016 and 2017 amounts, or should amend it out for them as well. Obviously, it would seem better to amend it out, although that will never cure the error, so, as previously stated, earnings on the 2016 and 2017 accumulations would continue to be subject to 409A until distributed, even if you include the original accumulations properly in income for 2016 and 2017 (or any later year when the statute is still open and you discover the problem).

The issue is not uncontroversial. Bloomberg Law carried an article dealing with some of the issues, by Jeffrey Kroh and William Fogleman of Groom, which you should be able to find just by Googling "409A statute of limitations." The article deals with operational violations of 409A, but as I stated earlier, the same issues appear to exist for plan document failures as well.

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