The IRS offers ways for deferred compensation plans to correct mistakes voluntarily - www.planadvisor.com

Correction Appended

The IRS offers ways for deferred compensation plans to correct mistakes voluntarily

Elayne Robertson Demby – 08/26/2008

http://www.planadviser.com/magazine/article.php/2729

When
Congress added section 409A to the Internal Revenue Code (IRC), it also
imposed stiff penalties for failures to follow the rules. So, if
clients make any mistakes in operating nonqualified deferred
compensation (NQDC) plans, such as forgetting to actually deduct
deferred amounts from executive’s paychecks, those executives could
face big unexpected tax bills.

Now there is a way that companies can avoid having
those penalties imposed on executives for the firm’s unintentional
mistakes in operating NQDC plans.

Last December, the Internal Revenue Service (IRS)
issued guidance detailing how section 409A NQDC programs can fix
certain types of plan problems. If certain procedures are followed,
participants, i.e., company executives, will not incur the rather
draconian tax penalties. Essentially, the new guidance allows employers
to correct a problem voluntarily, says Michael Melbinger, a partner
with Winston & Strawn LLP in Chicago. “You don’t have to try to
sweep the problem under the rug and lose sleep over it,” he says.

While the correction program is a good thing, it
could be better. “It’s a good thing but it’s just a start,” says Brigen
Winters, a Principal at the Groom Law Group in Washington. It’s a
preliminary step toward what companies need, he says, particularly
after the transition period for 409A applicability ends at the end of
this year.

Part of the problem is that the scope of the
program is very limited, says Bruce Ashton, a Partner with Reish
Luftman Reicher & Cohen in Los Angeles. “That said, it’s better
than nothing,” he comments.

Advisers need to be aware that the relief is
available, says Ashton. If advisers are proactive and observe what is
going on and a problem crops up, then they can help fix the problem.
“If they find out that something hasn’t happened in an NQDC plan, and
if they know the [correction] rules, they can go to the client and say,
‘We can fix that,’” he says.

For the last few years, advisers have been focused
on getting NQDC plans in compliance with section 409A, says Melbinger.
This notice, he says, adds another item to advisers’ “to do” lists,
because, in order to take advantage of the program, there need to be
procedures in place so that operational errors do not occur. “It’s not
onerous, but it has to be done,” he says.

The voluntary correction program is detailed in
Notice 2007-100. In this notice, the Treasury Department and IRS
outlined a procedure that gives firms the ability to correct
operational failures to comply with section 409A of the IRC. Section
409A was signed into law as part of the American Jobs Creation Act in
2004 to address concerns over reported abuses in NQDC plans.
Specifically, Section 409A now states that distributions from NQDC
plans may be made only after: (1) separation from service; (2)
disability; (3) death; (4) a period of time specified in the plan or
election; (5) change of control or change in ownership of corporate
assets; (6) unforeseeable emergency. Distributions to top executives
are limited further. If an officer making more than $130,000 or a 1%
owner with compensation greater than $150,000 separates from service,
he may not get distributions for six months. In 2006, the IRS extended
the date for compliance with the new section 409A rules through the end
of 2007.

Specifically, Notice 2007-100 implements a
voluntary correction program for 409A plans and provides relief for
certain unintentional operational failures that are corrected in the
same year—for example, an unintentional failure to comply with plan
provisions that satisfy the requirements of section 409A or an
unintentional failure to follow the requirements of section 409A in
practice. If the operational failure is corrected in the same taxable
year, then participants do not incur a taxable event.

Essentially, if a 409A program has an unintentional
operational error that is detected and corrected on a timely basis,
then executives may not be subject to penalties. Not only does the
failure have to be unintentional, it cannot be a shortcoming in the
plan document language, but in the actual running of the plan itself.
Relief is not available with respect to any intentional failure to
comply with the terms of a plan or the requirements of section 409A in
the operation of the plan.

Additionally, relief is not available unless, in
addition to correcting the operational failure, reasonable steps are
taken to avoid a recurrence of the operational failure. Relief may not
be available if the same or a substantially similar operational failure
occurred previously.

Furthermore, not all operational errors qualify for
relief. Operational failures that qualify for relief include the
failure to actually defer the amounts or incorrect payments. For
example, if a company accidentally pays the executive amounts that
should have been deferred into the plan, then, as long as the employee
repays the money in the same tax year, the correction is recognized.

Relief is also available for amounts erroneously
paid to an employee from the plan if the money is repaid. For example,
if an employee is scheduled to receive $10,000 from a nonqualified plan
but is mistakenly paid $11,000, then relief is available upon repayment
of the $1,000.

If amounts are erroneously deferred into the plan,
then relief is also available. For example, if an employee elects to
defer 10% of a $100,000 bonus, and the employer mistakenly defers
$50,000 into the plan, the excess $40,000 will not be treated as
deferred if the employer corrects the error and pays the employee the
$40,000.

Relief is not available if the plan itself does not
meet the requirements of section 409A and any guidance related to it.
Relief is also not available if the operational failure is “egregious,”
or related to the participation in an “abusive tax avoidance
transaction.”

Limited Scope

There are also strict limitations on when
corrections can be made. Generally, operational failures only can be
corrected within the same tax year. Thus, a problem that occurs in
March 2008 and discovered in May 2008 is correctable without penalties.
One made in December 2008 and discovered in January 2009 may not be.

However, until 2010, when this relief is no longer
available unless extended, if an operational failure is not discovered
until after the end of the tax year, the executive affected by the
failure may not be liable for the premium interest penalty taxes, but
he might still be liable for the 20% penalty tax. For example, an
employee elects to defer 8% of a 2007 $10,000 bonus into the plan, but
the employer defers 10% into the plan. The mistake is not discovered
until 2008, at which time the account balance includes $15 earned on
the excess $200 credited to the account. The employer can pay the
employee $215. In addition to income taxes, the employee is required to
pay the additional 20% penalty tax on the $215, but not the premium
interest tax. The total amount cannot exceed the limit on 401(k)
deferrals, i.e., $15,500 for this year. The small amount limit
($15,500) reduces the availability of this relief quite a bit, notes
Winters.

The voluntary correction program is not available
in any year that the employer is in a “substantial financial downturn”
or “otherwise experienced financial or other issues that indicated a
significant risk.” The IRS has not yet defined what this means and one
can argue the current economic environment is such that all firms this
year are in a financial downturn, meaning relief is not available, says
Ashton.

Any business that takes advantage of this voluntary
correction program relief must file, along with its federal income tax
return for the taxable year in which the failure occurred, notice to
the IRS. The notice must be entitled “Section 409A Relief Under Section
II of Notice 2007-100.”

Although limited, it is understandable why the IRS
would take such a cautious approach, says Ashton. In the past, when the
IRS introduced voluntary corrections programs for qualified plans, he
says, the service took a similar cautious approach. “All the corrective
programs started out as limited-scope experimental programs,” he says.

The IRS asked for comments on the program, although
the comment period ended March 3, and will probably issue more guidance
in the near future, maybe as soon as this fall, say the experts. The
IRS already is signaling that it may broaden this policy, says Winters.
For example, he says, it asked for comments about extending relief for
transactions in another tax year above $15,500.

Additionally, one reason why the IRS has been so
cautious in its approach to granting relief, says Winters, is that it
is unsure if it has the statutory authority to go any further.
Congress, however, has indicated that it is willing to provide the IRS
with the authority. The Senate Finance Committee has attempted to add
amendments to a bill for small-business tax relief and minimum wage
legislation, although the amendment was dropped from the ultimate bill.
Since then, says Winters, Senate Finance staff subsequently worked on
possible amendments to this proposal, including a possible correction
mechanism that could apply to failures to satisfy the 409A limit and
possibly also to failures under current law 409A.

It’s hard to say how the program is working yet,
says Winters. Few firms have used it at this point since nonqualified
programs are still in a transition period. On the qualified plan side,
Ashton says voluntary corrections programs are considered an enormous
success.

In the end, all the experts agree that the notice
is a step in the right direction. “It’s good that the rules are out
there, although, for the time being, they have limited utility,” says
Ashton.

After all, notes Winters, the penalties for
violating section 409A are rather draconian. They include taxation of
all amounts under all NQDC plans of the employer, not just the violated
amounts, plus an additional 20% penalty tax and interest. Having some
relief, even if it is only for certain errors, is a good thing.