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

With respect to nonqualified deferred compensation plans, it is important to note that the IRS EPCS and the SCP correction procedures applying to qualified plans¹ do not apply to nonqualified deferred compensation plans, whether subject to Section 409A or not.

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

Notices 2009-113 and 2010-6 were expanded in late 2010 under Notice 2010-80. Notice 2010-80 modified Notice 2008-113, governing operational errors, to eliminate employer and employee reporting when an operational error correction is made within the same year as the error. It also modified Notice 2010-6, governing documentation errors, to allow correction of severance/separation plans with incorrect release of claims provisions if completed by December 31, 2012, and to allow nonqualified plans “linked” to other nonqualified plans (e.g., excessive benefit plans) and stock plans to use Notice 2010-6 to make corrections for document failures prior to that date. However, this last opportunity to correct the form errors outlined in Notice 2010-80 expired on December 31, 2012.

Documentary Error Correction

In the case of documentation errors, there are some errors that may be corrected without an amendment or paying any tax or penalties at all. Notice 2010-6 provides an extensive digest of various (but not all possible) documentation errors and the remedies that permit the employee to report less than the amount that would be required in the worst case Section 409A taxation situation and avoid the full Section 409A 20 percent excise and premium interest penalty taxes in many cases. Notice 2010-6 highlights specific documentation errors, with corrective procedures and costs.

Because it is focused on language and structures that create errors under Section 409A, it also provides a useful checklist for plan drafting to avoid common Section 409A drafting errors for various types of Section 409A-covered plans. Notice 2010-6 also gives new plans a grace period of 12 months from the effective date to correct errors found in the plan documentation.

Operational Error Correction

In the case of operational errors, Notice 2008-113 defines operational errors based on Section 409A requirements. It organizes them into useful categories of Section 409A operational violations, such as distributions made before the six month delay period for highly compensated employees. It outlines the Notice 2008-113 special corrective procedure required to correct that category of error without having to incur the worst case tax event. In general, full relief is available when operational errors involving any employee are discovered and corrected in the same tax year, and by the second tax year in the case of employees that are not “insiders,” as defined under Section 16(b) of the federal securities laws notwithstanding whether the employer is a public or private corporation. In other words, the “insider” rule for 409A correction purposes applies to public companies and also to private, closely-held for-profit and tax-exempt organizations by analogy.

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Planning Point: Notice 2010-6 allowed a final opportunity to correct documentation errors in plans not later than December 31, 2010, and to have these corrections apply retroactively back to the January 1, 2009, effective date for actual document compliance. As of January 1, 2011, this opportunity passed, and sponsors now must use Notice 2010-6, as modified by Notice 2010-80 to make formal corrections. In addition, all errors in plans, whether of a documentary or operational nature, usually can be corrected in order to minimize the negative tax impact on an employee if the error is identified and corrected sooner rather than later, especially if caught and corrected in the same tax year. Therefore, plan sponsors should routinely audit their plans in the late fall to discover and correct any operational or documentation errors before the end of the current tax year. They should also build in a review audit in the first year of a plan in order to catch initial plan drafting errors and then correct them during the correction grace period provided for new plans that do not generally constitute an error or require formal correction under Notice 2010-6.

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Planning Point: On May 9, 2014, in a subcommittee meeting at the American Bar Association annual conference, the IRS announced that it was launching a new, limited CIP 409A audit. Although the audit was to impact only 50 public companies also targeted for an audit on employment taxes, the audit was used to sharpen IRS future audit practice on 409A plans for even broader audits that will surely follow.⁶

This and prior IRS 409A audit initiatives suggest the wisdom of periodic “self-audits” of both the required documentary and operational compliance. A periodic self-audit makes sense anyway, since the special correction programs, which provide a less than worse-case results under the penalty provisions of 409A, are NOT available for companies once they are in an IRS audit. Moreover, the IRS currently applies a strict application of 409A penalties when they are discovered in audit. Therefore, it is recommended that companies routinely self-audit their 409A plans annually for operational compliance. Documents can be reviewed less frequently, but certainly should be reviewed any time they are amended or restated. However, compliant plan documentation and operation should always be in sync at all times.

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