After years of delay, the IRS started 2010 off right by releasing Notice 2010-6 ("Notice 2010-6") which implements a correction program for deferred compensation documents that are not compliant with Section 409A of the Internal Revenue Code ("Section 409A"). Because of the complexity and expansive scope of the Section 409A rules, practitioners and taxpayers have been pushing for a document correction program since the enactment of Section 409A in 2005. Although the correction program itself is complicated, it provides a limited opportunity to avoid or reduce the harsh impact of the failure of deferred compensation documents to comply strictly with Section 409A and provides an incentive to act in 2010. This article provides a general overview of some of the key provisions of Notice 2010-6.
Background of Section 409A
Section 409A imposes a variety of requirements and restrictions on deferred compensation arrangements. In general, "deferred compensation" is any arrangement under which a service recipient promises to pay the service provider in a year after that in which the promise is made. Although this article uses the terms "employer" and "employee," Section 409A uses the terms "service providers" and "service recipients." Service providers include not only employees, but also directors and certain independent contractors. Service recipients include all types of employers, whether public, private, or nonprofit.
One of the most significant restrictions of Section 409A relates to the timing of distributions. In general, distributions must be payable only upon death, disability, separation from service, change in control, or an unforeseeable emergency, or pursuant to a fixed date or fixed schedule. In addition, there is a prohibition on the acceleration of the time or schedule of payments.
Deferred compensation arrangements subject to Section 409A were required to be in compliance in both form and operation as of January 1, 2009. In 2008, the IRS released Notice 2008-113, a limited correction program that provided relief for certain operational failures due to unintentional practices or operations of an employer. However, there was no similar program for correcting deferred compensation documents that were not drafted in compliance with Section 409A.
Penalties for noncompliance with Section 409A are significant for the employee and include:
- Immediate taxation of vested, but as yet unpaid, compensation;
- A penalty equal to 20% of the vested amount; and,
The end result is that an employee expecting to pay the usual 35% of the deferred compensation amount in federal taxes could end up paying more than twice that amount. To make matters worse, the tax is due in the year in which the violation occurs. Thus, the employee could end up owing (and having to pay) tax on compensation that will not be received until sometime in the future. Even a minor or innocent mistake can trigger a huge tax liability for the employee. Therefore, Notice 2010-6 is a welcome relief.
IRS Notice 2010-6
The purpose of Notice 2010-6 is to encourage taxpayers to identify drafting errors that violate Section 409A and voluntarily correct those errors promptly. Although Notice 2010-6 can be beneficial, it does include some potential traps. The rules are very mechanical and must be applied carefully to avoid negative tax results.
Notice 2010-6 does not allow the correction of all errors. It applies only to inadvertent and unintentional document failures and generally does not provide relief for stock rights. In addition, relief is not available if the federal income tax return of the employer or employee is under examination with respect to deferred compensation.
Once a document defect is identified, the employer must take commercially reasonable steps to identify and correct all other substantially similar document defects. In addition to correcting the error, the employer and each employee affected by the correction must comply with various IRS reporting requirements.
Types of Errors
As previously mentioned, all deferred compensation arrangements subject to Section 409A were required to be in compliance with its requirements by January 1, 2009. To be in compliance, the document is required to include specifications of the amount of compensation deferred; the time and form of payments; and, in the case of public companies, provisions for a six-month delay in payments to certain employees following a termination of service. If the document does not include certain "magic language" or does not exclude certain forbidden language, the document is deemed to violate Section 409A.
Although relief is not available for all documentary failures, Notice 2010-6 addresses and gives relief for a broad range of failures such as:
- Payment events (such as "separation from service") that are based on definitions that do not comply with Section 409A;
- Payments that are improperly dependent upon employee action (such as the execution of a release or noncompetition agreement);
- Initial deferral elections that do not comply with Section 409A;
- Impermissible employer or employee discretion regarding the timing of a payment;
- Failure to provide for a six-month delay in payment for certain key employees;
- Impermissible reimbursement of benefits;
- Impermissible payment periods following a payment event (i.e., within 120 days of disability); and,
- Impermissible payment events (such as payment upon an initial public offering).
To obtain relief, the employer must follow the specific correction procedure outlined in Notice 2010-6 for the particular type of document failure.
The correction of certain document failures (such as payments that are based on improper definitions or payments that are improperly dependent on employee action) will relieve the employee of all Section 409A liability provided the correction does not impact the operation of the pre-correction arrangement for one year after the correction. If the correction does impact the operation of the pre-correction arrangement, the employee is not relieved of all liability, but does escape the payment of interest and is required to pay only a percentage (typically 50%) of the tax and penalties that otherwise would have been due under Section 409A.
Special Relief for 2010
Notice 2010-6 provides special retroactive relief for documents that are corrected before December 31, 2010. If a defect is corrected before that deadline, the document will be treated as being corrected as of January 1, 2009. However, any amount of deferred compensation that actually is paid to the employee before December 31, 2010, as a result of the defect will be treated as an operational failure and must be corrected in accordance with Notice 2008-113 (which may require income inclusion).
The following example is a simple illustration of the application of Notice 2010-6:
The chief executive officer ("CEO") of ABC Company ("ABC") has an employment agreement which entitles CEO to $50,000 upon separation from service from ABC. However, the agreement defines the term "separation from service" to include a transfer of CEO's employment to ABC's wholly-owned subsidiary, XYZ Company ("XYZ"), which is in violation of Section 409A.
1. On January 10, 2011, CEO transfers to XYZ and receives $50,000. On March 1, 2011, ABC discovers that the definition of "separation from service" in CEO's employment agreement is not in compliance with Section 409A and amends the agreement accordingly. Because the agreement was not corrected before CEO transferred to XYZ, the document violates Section 409A. As a result, CEO must pay (i) tax on $50,000; (ii) an additional penalty of $10,000 ($50,000 x 20%); and, (iii) applicable interest.
2. Assume the same facts as above except that CEO transfers to XYZ on July 1, 2011.
The agreement was corrected on March 1, 2011 ("Correction Date"), before CEO transfers, but the transfer occurs within one year after the Correction Date. Pursuant to the corrected employment agreement, CEO will not receive the payment of $50,000 until CEO has a "separation from service" correctly defined pursuant to Section 409A by excluding a transfer to XYZ. Provided CEO does not receive the $50,000 as a result of the transfer because of the correction, CEO nevertheless will be required to pay taxes on the deferred compensation, albeit a reduced amount approximately equal to 50% of the amount CEO had to pay under Scenario 1 above – that is: (i) tax on $25,000 ($50,000 x 50%); (ii) an additional penalty of $5,000 ($25,000 x 20% penalty); and, (iii) zero interest.
As a result of the correction to the documents, and as required by Section 409A, CEO may not actually separate from service for several years. Therefore, for tax year 2011, CEO will be required to pay taxes on an amount ($25,000) that was not received and a penalty of $5,000. To help ease the tax burden, the Section 409A regulations give ABC, the employer, discretion to accelerate payment of the deferred compensation to CEO to the extent CEO is required to include an amount in income because of the Section 409A violation. Therefore, ABC could accelerate payment of the deferred compensation to CEO in the amount of $25,000.
3. Assume the same facts as Scenario 2 above except that ABC corrected the employment agreement on December 1, 2010. Under Notice 2010-6, the correction is treated as having been made on January 1, 2009. Although CEO transferred within one year after the actual Correction Date, CEO will escape all Section 409A liability (assuming all other requirements of Notice 2010-6 are satisfied) because of the retroactive date of the correction (January 1, 2009) allowed by Notice 2010-6.
Businesses may discover they have violated Section 409A despite their good faith efforts to comply. The above example demonstrates how a violation can affect an employee adversely and how Notice 2010-6 can reduce or avoid the impact. The IRS already has begun Section 409A audits which, as mentioned above, terminate eligibility to use the procedures and receive the protections of Notice 2010-6, and intends to increase audit activity in this area. As a result, employers should act quickly and work diligently with legal counsel to identify and correct noncompliant deferred compensation documents before it's too late.
© 2010, Ward and Smith, P.A.
For further information regarding the issues described above, please contact Deborah B. Andrews.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.