3549 / What penalties can be imposed under Section 409A?

IRC Section 409A imposes substantial penalties for failing to meet either the Section 409A form (documentation) or operational (administration) requirements at inception and during the life of a covered plan. One of the peculiarities of Section 409A is that the tax falls on the participant and not the employer.¹ In the worst-case situation, any violation of the Section 409A documentary or operational requirements results in retroactive constructive receipt, with the vested portion of the deferred compensation being taxable to the participant back to the date of the violation, which might be the date of the intended deferral.²

However, in June 2016, the IRS released technical proposed amendments³ to the inclusion regulations that limit the ability of plan sponsors to use the existing exclusion of nonvested amounts from taxation to make changes in the time and form of payment in a plan document without engaging the subsequent election five-year setback. Under the proposed amendment, the nonvested amounts of a benefit cannot be excluded from the calculation of the tax in the event of a violation unless the following conditions are met: 1) the plan provisions must be noncompliant prior to the correction of the document, meaning the amendments to the document must not create the noncompliance; 2) there must be no prior history of the employer making and correcting such intentional failures; 3) there must be a consistency in how the employer makes corrections in such cases; and, 4) there must be full conformity and compliance with the IRS guidance on such plan corrections (i.e., Notice 2010-6).⁴ IRS treatment of prior instances of using the pre-June 22 exclusion of nonvested amounts in such intentional violation of 409A instances is uncertain. No specific grandfathering of such instances was provided in the June 2016 proposed amendments.

This proposed amendment apparently ends a practice of some sponsors intentionally making changes in time and form of payment (probably at the request of a senior plan participant) on individualized supplemental plans in which the benefits were substantially nonvested until a late distribution date, like retirement. By not applying the subsequent election five-year set-back rule, a sponsor violates Section 409A, but avoids reporting because of the prior exclusion for nonvested benefits. In such cases now, all amounts, whether non-vested or vested, must be included in the calculation of the penalty taxes.

In addition, IRS Counsel has taken the position that the correction of a form error prior to the date of vesting, but in the tax year of the vesting date, did not cure the plan sponsor’s failure to correct the error in time. Therefore, the entire amount of the plan benefits must be included in taxable income under Section 409A. The Chief Counsel’s memorandum indicated that 409A and the proposed regulations governing income inclusion require that the form correction should have been made before the end of the tax year prior to the tax year in which vesting occurred for it to have avoided application of the 409A inclusion rules for the error in form.⁵

In addition to the normal income tax on the compensation, the participant must pay an additional 20 percent tax, as well as interest at a “premium” penalty rate 1 percent higher than the normal AFR underpayment rate.⁶ Fortunately, there are now methods under Notices 2008-113 (in the case of operational errors), Notice 2010-6 (in the case of documentation error), and Notice 2010-80 (updating both prior Notices) for correcting many common documentary and operational errors that may avoid the full impact of taxation under Section 409A.

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Planning Point: With regard to penalties for violations of Section 409A, at least one state – California – currently adds its own 5⁷ percent excise state income tax penalty when the federal penalty is imposed for a Section 409A error. Planners should therefore check the relevant applicable state rules at the time any voluntary deferral plan is created, to determine the additional state income tax exposure for likely eligible participants. If the sponsor and its participants are substantially all located (and likely to remain) in a state(s) that also imposes its own penalty excise tax, a discussion of other potential approaches to a 409A nonqualified deferred compensation plan may be in order if the total potential federal and state income tax for an error appears excessive. If the plan desired is an employer-paid SERP, the 409A penalty state income tax possibility may be less of an issue, but still ought to be discussed.

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