The IRS has issued new guidance (Notice 2010-6) that provides valuable assistance in dealing with nonqualified deferred compensation plans under Section 409A of the Internal Revenue Code (the “Code”). Prior to this guidance, there was no means to correct an incorrectly drafted nonqualified deferred compensation plan (as the documentary compliance “transition period” ended December 31, 2008). This was in contrast to certain “operational errors” for which corrective guidance had been issued by IRS in Notice 2008-113.

The newest 409A guidance now provides a method for correcting many types of plan document failures, and also provides helpful clarifications regarding some common plan provisions that will, under certain circumstances, be considered compliant with Code Section 409A requirements. For example, it had been unclear if a plan or agreement subject to Section 409A calling for payments to be made “as soon as practicable” following the occurrence of a specified permissible payment event (e.g., payment to be made as soon as practicable following a separation from service) would trigger a Section 409A violation because no express time of payout was specified. Notice 2010-6 makes clear that this type of language, while not explicitly satisfying the requirements of Code Section 409A that time of payment be specified, will be considered to be compliant with Code Section 409A so long as payment is actually made during the same taxable year as the specified event or, if later, by the 15th day of the third month following the date of the specified event. Similar help is provided regarding where the phrase “termination of employment” is used as a payment event, rather than the correct term “separation from service” (as spelled out in the relevant regulations) so long as the termination is, in actuality, also a separation from service.

The notice allows correction of certain document failures without requiring any inclusion of additional income or taxes under Code Section 409A unless the change has an actual impact on plan operation within one year following the date the correction is made. For example, a noncompliant definition of “separation from service” that could have permitted payments in the absence of a bona fide 409A separation from service can be corrected by eliminating the non-compliant elements of the definition. If, however, an event occurs that would have been an impermissible payment event within one year of the correction action, 50% of the deferred compensation subject to the original noncompliant provision must be included in the participant’s income under Code Section 409A (plus the 20% additional Section 409A penalty tax, but not including the “interest” based additional tax). There are a number of similar document failures that are corrected along the same lines. But note, as discussed below, for certain corrections made during 2010, this income inclusion may be eliminated.

Other document failures (such as provisions for payment dates all of which fail to comply with Code Section 409A) can be corrected by making specific modifications to the plan and by treating 50% of the benefit as taxable under Code Section 409A.

The permitted corrections provided for under Notice 2010-6 are unavailable for any arrangement that is under examination (this includes not only an audit of an employee’s or an employer’s tax return with regard to nonqualified deferred compensation, but also receipt by the employer or employee of a written notice of examination, information document request or notice of proposed adjustments), is considered to be intentional failures or is directly or indirectly connected to any “listed transaction” (i.e., a tax avoidance transaction that has been identified as such by the IRS). There are also certain information and reporting requirements that apply to corrections made under the terms of this guidance.

Other issues addressed in Notice 2010-6 include:

• Transition relief permits corrections of certain document failures without current income inclusion or additional taxes under Section 409A, if the document failure is corrected by December 31, 2010, and if any operational failures resulting from the document failure are also corrected in accordance with Notice 2008-113 (the prior program for Section 409A operational corrections).
• The Notice provides relief for correction of new plans (in limited circumstances).
• The Notice clarifies certain aspects of Notice 2008-113, including how to handle amounts withheld when determining required repayments, calculation of amounts that must be repaid by an employee where the original payment was in property and in calculation of amounts to be paid or repaid where a deferral was deemed to have been invested in property.

This entry was written by Warren Fusfeld.