Last Chance to Correct Penalty-Free – Section 409A, Notice 2010-6, and Transition Relief in 2010 - 16 Nov 2010

Last Chance to Correct Penalty-Free – Section 409A, Notice 2010-6, and Transition Relief in 2010

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At the start of this year, the IRS issued Notice 2010-6, which
provides methods for employers to correct documentary failures under
section 409A of the Internal Revenue Code. The Notice provides
additional transition relief for this year which allows an employer to
correct certain documentary failures without penalty under section 409A.
Because this relief is available, employers should review or
have reviewed for them their severance, change-in-control (or CIC),
executive health care and employment agreements, and nonqualified plans
that are subject to section 409A (“section 409A arrangements”).

Brief Overview of Notice 2010-6
Notice
2010-6, 2010-3 I.R.B. 275 (Jan. 19, 2010), allows employers to correct a
number of documentary failures under section 409A arrangements. These
include:

• Correction of impermissible definitions of otherwise permissible payment events, including:
  
  
  
  • Impermissible definition of separation from service
    
  
  
  • Impermissible definition of change-in-control event
    
  
  
  • Impermissible definition of disability
  
  
  
  


• Correction of impermissible payment periods following a permissible payment event, including:
  
  
  
  • Impermissible payment periods of longer than 90 days following an event
    
  
  
  • Impermissible conditioning of severance payments upon signing a release
  
  
  
  


• Correction of impermissible payment events and payment schedules, including:
  
  
  
  • Impermissible payment events
    
  
  
  • Impermissible alternative payment schedules
    
  
  
  • Impermissible discretion following a payment event
    
  
  
  • Impermissible discretion to accelerate payment
    
  
  
  • Impermissible reimbursement or in-kind benefits
  
  
  
  


• Correction for failure to include a six-month delay for specified employees
  


• Correction for provisions on impermissible initial deferral elections

In addition to providing guidance on correcting these document
failures, the Notice also provides guidance and cause for concern. For
example:

• Termination of employment. The Notice indicates that the phrase
  “termination of employment” may violate section 409A if it leads to
  payments in situations not permitted under section 409A (for example,
  where an employee reduces their hours or is re-hired as an independent
  contractor providing significant services after termination of
  employment). Note that not all terminations of employment are a
  separation from service for purposes of section 409A. It is possible to
  have a separation from service that is not a termination (or a
  termination that is not a separation from service). Only a separation
  from service is an acceptable payment trigger under section 409A. Prior
  to the Notice, the IRS had informally indicated that the term
  “termination” was acceptable in agreements. Now employers should review
  agreements to see if it needs to be clarified. See Notice 2010-6,
  Section IV.B.
  


• Severance payment timing. The Notice states that severance
  payments contingent on a release of claims or the end of a rescission
  period may violate section 409A (if the compensation to be paid is
  subject to section 409A). See Notice 2010-6, Section VI.B.

The correction of a document failure requires several steps,
including amending the section 409A arrangement, attaching a statement
regarding the correction to the employer’s federal income tax return,
and providing a statement regarding the correction to affected
participants who are to attach it to their federal income tax returns.
In addition, to be effective an employer must correct the failure in all
of its section 409A arrangements that have a similar failure. Thus,
although the Notice provides relief, there are burdens on employers and
affected participants.

Transition Relief Available in 2010
The
Notice provides that if a document failure is corrected by December 31,
2010, then the document is deemed to have been corrected as of January
1, 2009, the date on which plan documents were to be in a form that
complied with section 409A. If a payment has been made that would not
have occurred under the corrected document, then that payment is to be
corrected using the operational failure guidance found in Notice
2008-113 by December 31, 2010.

There is also transition relief
for linked plans that extends through December 31, 2011. The Notice
requires that the linked plans must have identical time and form of
payment. This transitional relief is important because it is not
available once the transition period expires on December 31, 2011.

Conclusion
Employers
should consider having severance, CIC, executive health care and
employment agreements, nonqualified deferred compensation plans,
restricted stock unit and other arrangements subject to section 409A
reviewed again before the end of 2010 for potential documentary
failures. Although the Notice allow correction in subsequent years, the
transition relief available in 2010 offers a chance to correct a number
of such failures on a penalty-free basis.

If you have questions
about Notice 2010-6 or section 409A, please contact the attorney in the
Benefits and Compensation practice group with whom you work.

Disclaimer
©2010
Dorsey & Whitney LLP. This article is intended for general
information purposes only and should not be construed as legal advice or
legal opinions on any specific facts or circumstances. An attorney
client relationship is not created or continued by reading this
communication. To comply with certain Internal Revenue Service (IRS)
rules, we must inform you that any U.S. federal tax advice contained in
this article is not intended or written to be used, and cannot be used,
by any person for the purpose of avoiding any penalties that may be
imposed by the IRS. Members of the Dorsey & Whitney LLP group
issuing this communication will be pleased to provide further
information regarding the matters discussed therein.