3553 / What are the correction procedures under Section 409A?

Fortunately, it is not always necessary to suffer worst case taxation under Section 409A for an unintentional error in either plan documentation or operation. The IRS has released three notices, one that addresses Section 409A documentation errors, Notice 2010-6,² one that addresses Section 409A operational administrative errors, Notice 2008-113,³ and Notice 2010-80 that updates both on certain select issues.⁴ All notices require that certain preconditions be met to take advantage of the special correction processes made available. In general, the notice correction procedures allow for corrections based on the timing of the correction of the error, the party involved (whether an “insider” or another employee), and in some cases the magnitude of the error.

The general remedy under the notices is to include in an employee’s income only the amount in error, in the case of operational errors, or some specified portion of the amount, such as 50 percent or 25 percent in the case of documentation errors. The 20 percent excise tax and premium penalty tax is often avoided, unless the affected participant is an “insider” (applying SEC Section 16(b) named officer standards, including by analogy those in closely-held companies). Both the employer and the employee have to report the correction of the error on tax returns to the IRS to claim the benefit of these correction procedures, unless the error is caught and corrected in the year of error. In that case, reporting is not required.

Some commentators think that it also may be possible to correct some documentary and operational errors in covered plans outside the parameters of these three notices under correction concepts applicable prior to the enactment of Section 409A. However, it should be recognized that the IRS takes a strict constructionist view of errors and error correction under Section 409A, and is unlikely to agree with these alternative procedures, even though 409A is additive law and arguably historic contract and tax bookkeeping correction procedures should remain available. However, plans excepted from 409A coverage and grandfathered portions of plans would remain covered by these pre-409A correction procedures and not the formal correction procedures provided in the notices.⁵