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
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
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
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
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
- Paying currently a plan benefit due in a later taxable
- 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
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
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
- The employer must take commercially reasonable steps to avoid a
- 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
* * *
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
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
* * *
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.
* * *
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.
* * *
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.
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