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Section Review

409A correction procedures*

Code section 409A deals with the tax treatment of deferred compensation plans. Failure to take heed of its provisions can be disastrous. Essentially an employee's entire deferred compensation account can become subject to immediate taxation at penalty rates, and employers can find themselves out of compliance with the code's reporting and withholding requirements. A notice issued by the Internal Revenue Service in 2008 (Notice 2008-115) describes the implications of a plan's becoming 409A noncompliant, and regulations on the subject (Treas. Reg. § 1.409A-4) have been proposed.

Employers must now tell employees about any deferred compensation currently subject to tax under code section 409A. Box 12 on Form W-2 (code Z) shows all compensation deferred under a noncompliant plan for the current year and all prior years to the extent not forfeitable and not previously included in gross income. The reportable amount is:

A plus B, minus C, where:

A = Total non-forfeitable amount deferred under the plan at the end of the current calendar year,

B = All amounts of deferred compensation paid or made available to the employee during that year, and

C = Deferred amounts that were included in the employee's income in a prior year.

Code Z alerts the IRS to the applicability of the additional 20 percent tax and the premium interest tax (to compensate for the time value of money) imposed on noncompliant 409A deferred compensation.

Valuing an employee's deferred compensation benefits at the end of a calendar year can be a big problem. In addressing this matter, the IRS has turned to guidance already developed under other code provisions. Notice 2008-115 breaks deferred compensation arrangements down into four groups, each with its own set of valuation principles: Account balance plans, non-account balance plans, stock rights and other deferred amounts. The proposed regulations provide more specific guidance.

An employee who receives a Form W-2 with an amount in box 12 coded Z will not be very happy. IRS guidelines obligate him to determine the amount reportable as income under code section 409A. He must also compute the two additional code section 409A taxes - the computation of which is addressed in the proposed regulations.

The bottom line is that 409A mistakes can be costly and, worse still, they can be made unwittingly. Scrivener's errors can cause plan documents to be 409A noncompliant. Operational mistakes can have the same result. The IRS, knowing the likelihood of unwitting 409A footfalls, published correction procedures in 2008 dealing with operational failures (Notice 2008-113). The important thing to keep in mind is that, if a mistake can be fixed, an employee's deferred compensation plan (including plans aggregated with it under 409A's plan aggregation rules) will be free from ongoing 409A taint. The proposed regulations also reflect the IRS's philosophy that corrected mistakes wipe the slate clean.

The operational correction procedures reflect the IRS's determination that correcting early is better than correcting later. If mistakes are caught in time, employees can avoid current taxation, the additional 20 percent tax and the premium interest tax. Other mistakes, if caught a little later, may result only in a regular tax plus the additional 20 percent tax on the erroneous amount. For the moment, catching a mistake beyond the last day of an employee's second taxable year after a failure occurs is too late.

Optimal results can be achieved if a mistake is fixed in the year of failure. Also, special rules favor failures involving small amounts, not greater than the annual limitation on employee elective deferrals to 401(k) plans. At the opposite end of the spectrum are insiders, with respect to whom mistakes can be corrected in a generally less favorable manner. Insiders are officers or directors, or those who have more than a 10 percent beneficial ownership interest in any class of their employer's equity securities, determined applying SEC rules.

What is surprising about the IRS's notice is how it defines operational failures. Most of the failures addressed are logical. Those that fall into an easily understood category are:

  • Paying currently an amount that an employee has elected to defer.
  • Paying currently a plan benefit due in a later taxable year.
  • Paying deferred compensation more than 30 days in advance of a due date falling within the same year.
  • Paying benefits to a "specified employee" during the six month period after his separation from service.
  • Fixing the exercise price of a stock right at below the fair market value of the underlying stock on the date of the right is granted.

What is not intuitive is the IRS's conclusion that an employer's erroneous deferral of current compensation is an operational failure. Why is the failure to pay current compensation not simply a breach of contract, rather than a unilateral decision to provide non-elective deferred compensation?

Taxpayers choosing to use the correction procedures have the burden of showing that they are eligible for the relief provided. According to the IRS:

  • The operational failure must be both inadvertent and unintentional.
  • The employer must take commercially reasonable steps to avoid a recurrence.
  • It is not possible to correct an erroneous payment made by an employer who experiences a substantial financial downturn in the year of payment, forewarning a significant risk that it will be unable to pay deferrals when due.
  • An employee may not correct an operational failure in a year after that in which it occurs if, for the year of the occurrence, his return is under examination "with respect to the plan."

The procedures also include extensive reporting requirements, applicable to both employers and employees. Taxpayers claiming relief must demonstrate that those notice requirements have been met.

* * *

The correction concepts can best be understood by considering the various ways in which two different types of operational failure can be corrected. Each example below assumes that the employee participates only in a deferred bonus plan.

Example one: Erroneous overpayment

In the first example, assume that "M" timely defers 50 percent of his 2009 bonus (50 percent of $100,000). On July 1, 2009, his employer pays him $90,000 by mistake and credits $10,000 to his deferred compensation account, resulting in an overpayment of $40,000. What correction procedures are available to M and his employer?

Case 1: M is not an insider. If, by Dec. 31, 2009, M repays $40,000 to his employer who credits $40,000 to his deferred compensation account, the erroneous payment will be treated as a nonevent. If repayment by then would create for M an immediate and heavy financial need, up to a 24-month deferral, with interest, is permitted.

Case 2: M is an insider. To achieve the case 1 result, M must, by Dec. 31, 2009, repay $40,000 with interest for the period the erroneous payment is outstanding, at a rate no less than the short-term applicable federal rate, based on annual compounding, for the month in which the erroneous payment was made. M's employer is taxed on the interest income. No interest will be due if the overpayment does not exceed the defined small amount ($16,500 for 2009).

Case 3: M is not an insider. The overpayment is discovered in 2010. M will not incur additional taxes if, by Dec. 31, 2010, he repays the entire $40,000 with interest computed as noted in case 2. M's Form W-2 for 2009 will show the $40,000 payment. M may, however, reduce his 2010 adjusted gross income by the $40,000 repayment. If repayment would cause M an immediate and heavy financial need, M can take advantage of the deferred payment provisions described in case 1.

Case 4: The facts are the same as in case 3, except that M is an insider and the overpayment is not discovered until 2010 or 2011. If M repays $40,000, with interest computed as noted in case 2 by Dec. 31, 2011 (the last day of the second year following the year of the failure), the additional 20 percent tax under section 409A, but not the premium interest tax, will be imposed only on the $40,000. M must receive from his employer a 2009 Form W-2 or form W-2c showing wages of $40,000 and the same amount in box 12 marked with a code Z. M cannot reduce his adjusted gross income by the $40,000 repayment.

Case 5: The facts are the same as in case 4, with two differences. M is not an insider and the operational failure is not discovered until 2011. Here, the correction method is as described in case 4 with one exception. Because M is not an insider, he is not required to pay interest to his employer on the $40,000 overpayment.

* * *

Three elements are common to these correction procedures. The IRS agrees that an employee need not repay an overpayment in cash; instead, other compensation due the employee before the mandatory repayment date may be reduced. Also, an employee's deferred compensation account balance can be adjusted for earnings or losses back to the date the overpayment should have been credited to the account, so long as the adjustment occurs by the prescribed repayment date. In no event, however, can an employee be made whole for the amount repaid.

One other correction method is available for overpayments of current compensation that do not exceed the current year's small amount ($16,500 in 2009). The recipient of a small amount may keep it. The quid pro quo is twofold. He will be taxed in the year of receipt. Second, the additional 20 percent tax under section 409A (but not the premium interest tax) will be imposed in the year of receipt only on the overpayment. When this procedure is used, the employer must issue a form W-2 or form W-2c for the year of payment, reporting the payment in box 12 using code Z, and the employee must file a return for that year, reporting the overpayment and the additional 20 percent tax. He must do so no later than the end of his second taxable year after that in which the failure occurred.

Example two: Excess deferral

The converse example involves an employer who erroneously defers current compensation (deemed by the IRS to involve an operational failure). Assume that "N" timely defers 50 percent of his 2009 bonus (50 percent of $100,000). By mistake, on July 1, 2009, his employer pays him $10,000 and credits $90,000 to his deferred compensation account, resulting in an over-deferral of $40,000.

Case 6: N is not an insider. If N's employer pays him $40,000 by Dec. 31, 2009, that amount will be shown as current compensation on his 2009 form W-2, and the additional taxes described in code section 409A will not be imposed. To compensate N for the late payment, N's employer could pay him interest by the end of 2009 to reflect the time value of money. N's account balance must be reduced no later than Dec. 31, 2009, to reflect the $40,000 payment. By the same date, N's "remaining account balance" can (but need not) be reduced by any amount earned on the $40,000 while it was credited to his account, or adjusted for losses. Per an IRS example, an adjustment for earnings means a forfeiture of earnings. The intent of the loss-adjustment provision is not, however, clear. If N's account consists of an initial deposit of $90,000 (the 2009 deferral), which, because of investment performance, falls by 60 percent to $36,000 on Dec. 31, 2009, what are the employer's options under the IRS notice?

Case 7: The facts are the same as in case 6, except that N is an insider. The same-year correction procedure is, with one exception, identical to that described in case 6. The account balance of an insider must be reduced by any earnings on the $40,000 erroneous deferral.

Case 8: N is not an insider. The operational failure is not discovered until 2010. If N's employer pays him $40,000 by Dec. 31, 2010, N will realize income of $40,000 in 2010, but he will not be subject to the additional 20 percent tax or the premium interest tax under section 409A. N cannot receive interest from his employer to reflect the time value of money. N's account balance must be reduced by the end of 2010 to reflect the $40,000 payment. In addition, his "remaining account balance" must be adjusted for earnings (and may be adjusted for losses) retroactive to the date the $40,000 was incorrectly credited to his account. Per the IRS notice, this adjustment must be made by the last day of N's taxable year in which the error occurred (2009 - not 2010 - in the example).

Case 9: N is an insider, and the operational failure is not discovered until 2010 or 2011. N must receive $40,000 from his employer by Dec. 31, 2011. His employer must issue a 2009 form W-2 or form W-2c, showing 2009 wages of $40,000 and $40,000 in box 12, with a code Z. By issuing this form, N's employer will avoid penalties or liability for failure to withhold on the amount deferred. N, on the other hand, will be subject only to the additional 20 percent tax under code section 409A, not the premium interest tax, imposed only on the $40,000 excess deferral. N's employer cannot pay N interest for the use of the $40,000. Further, N's "remaining account balance" must be adjusted for earnings (and may be adjusted for losses) retroactive to the date the excess deferral was incorrectly credited to his account. This adjustment must be made by the last day of the year in which N is paid the excess deferral.

Case 10: The facts are the same as in case 9, except that N is not an insider and the operational failure is not discovered until 2011. Under these circumstances, the correction procedures are identical to those described in case 9.

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One other correction procedure is available when an employee's excess deferral does not exceed the small amount for the year in which the operational failure occurs ($16,500 in 2009). Then, the employer may pay the excess deferral to the employee by the end of the employee's second taxable year following that in which the failure occurred, and report it on a form W-2 for the year of payment - as current wages and in box 12, using code Z. The employee will be required to include the payment in income for the year in which he receives it, when he will also be subject to the additional 20 percent tax imposed only on the payment received. The premium interest tax will not apply, nor will his employer be subject to penalties or liabilities for failure to withhold. Earning on the excess deferral through the date of payment must be forfeited or added to the payment, and losses allocable to the excess deferral must be permanently disregarded or subtracted from the payment made to the employee.

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Both examples illustrate the complexity of, and the planning opportunities presented by, the correction procedures in the IRS's 2008 notice. In any case involving an operational failure, it will behoove the parties to study carefully the available options and their impact. An employer must also determine its future reporting obligations should it or its employee choose not to engage in one of the permitted correction procedures.

*This article was completed before the issuance of IRS Notice 2010-6 dealing with plan document failures.

The Author

Patricia Ann Metzer, with Vacovec, Mayotte & Singer LLP in Newton, represents business entities, non-profits, individuals, estates and trusts in all areas of tax law. She has served as an associate tax legislative counsel with the U.S. Treasury Department, is the author of numerous texts and articles, and is a member of the American College of Tax Counsel.

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