Compliance with Sec. 409A requires a great deal of attention to detail. It is unlikely that an arrangement can comply with Sec. 409A without the establishment of, and perfect adherence to, flawless administrative procedures. Despite the detailed regulations and other guidance that the IRS has issued, new questions continually arise as to the proper application of Sec. 409A to various types of nonqualified deferred compensation arrangements.
Given the complexity of Sec. 409A, it seems inevitable that taxpayers will make mistakes as they attempt to comply with it. Fortunately, the IRS has established a correction program for certain violations of the Sec. 409A rules. This program, which is set forth in Notice 2007-100, provides for the self-correction of certain unintentional operational errors without any penalties if the errors are corrected within the same tax year of the service provider in which the errors occur. (The term "service provider" refers to individuals who are providing services, such as employees, independent contractors, or board members.)
For certain errors that are not corrected by the end of the tax year in which the error occurs, the program permits self-correction with limited penalties as long as the amount involved in the error is below a prescribed threshold and the error is corrected by the end of the service provider's second tax year following the tax year in which the error occurred. The self-correction program for the latter category of errors generally is available only for errors that occur in a tax year beginning before January 1, 2010. (The IRS intends to establish a permanent correction program but has not yet done so.) The program does not provide for selfcorrection for any errors that are corrected later than two tax years following the end of the service provider's tax year in which the error occurred. This article summarizes the self-correction program.
General Rules
Benefits of the Sec. 409A Correction Program
- No Sec. 409A penalties for certain errors corrected within the same tax year in which the error occurs, regardless of the amount involved.
- Limited Sec. 409A penalties for certain errors that are not corrected within the same tax year in which the error occurs but are corrected by the end of the employee's second tax year following the tax year in which the error occurred, and when the amount involved is equal to or less than the limit on elective deferrals to qualified plans ($15,500 or less in 2007 or 2008, as indexed for inflation).
Errors That Cannot Be Corrected Under the Program
- Exercise of a stock option or stock appreciation right that results in a failure to comply with Sec. 409A.
- Intentional errors.
- Egregious errors.
- Errors directly or indirectly related to participation in an abusive tax avoidance transaction.
General Condition for Using the Program
The employer must take commercially reasonable steps to avoid a recurrence of the error.Special Conditions Imposed for 2009 and Beyond If the Same or a Substantially Similar Error Has Occurred Previously
The employer must demonstrate that:- It had established practices and procedures reasonably designed to ensure that the error would not recur.
- It had taken commercially reasonable steps to avoid a recurrence of the error.
- The error occurred despite its diligent efforts.
Information Reporting Requirements
- The employer must attach a statement to its original income tax return (not an amended return) that includes information such as each affected employee's name, a brief description of the error (including the amount involved and the date the error occurred), the steps taken to correct it, and the date those steps were completed.
- Deadlines:
- Errors corrected within the same tax year in which the error occurred: Attach to original tax return for the year in which the error occurred.
- Errors corrected later: Attach to original tax return for year in which error is discovered.
- The employer must provide a statement to each affected employee containing information similar to that described above.
- Deadlines:
- Errors corrected within the same tax year in which the error occurred: By the deadline for providing Form W-2 to employees for the year in which the error occurred.
- Errors corrected later: By the deadline for providing Form W-2 to employees for the year in which the error was discovered.
- The employee must attach the statement provided by the employer to his or her original tax return for the year in which the error was discovered (applies only to second class of relief).
- If the employer's or employee's federal tax return is audited by the IRS for years in which the relief provided by the program was relied upon, the taxpayer (i.e., the employer or employee whose return is being audited) must disclose use of the program to the IRS agent upon commencement of the audit.
Errors That Can Be Corrected Under the Program
Exhibit 1: Failure to defer an amount for which a deferral election had been made, or distribution of an amount that should not have been distributed.
Note: Distributions made before the end of the required six-month delay period for specified employees of public companies cannot be corrected under this method but can be corrected under another method, as described in Exhibit 3.
The correction method and limited relief are not available for years in which the employer experienced a substantial financial downturn or otherwise experienced financial or other issues that indicated a significant risk that the employer would not be able to pay the amount deferred when the payment became due.
No Sec. 409A penalties if the error is corrected by the last day of the tax year in which the error occurs
(Notice 2007-100, §II.B)
| Correction Method | Details |
|---|---|
| Employee
repays the amount to the employer by the last day of
his or her tax year in which the error occurred. Employee must pay interest to the employer, but only if the following circumstances apply:
|
The employee’s repayment can be accomplished by
direct repayment to the employer or through payroll
reduction. There is no Form W-2 or Form 1099 reporting with respect to the erroneous amounts. To the extent employment taxes have been erroneously withheld and paid, adjustments should be made under Sec. 6413. If interest is required to be paid, use the short-term applicable federal rate under Sec. 1274(d)(1). If the employee’s account is adjusted for lost earnings, the deadline for doing so is the last day of the employee’s tax year in which the error occurred. If it is impracticable to make the adjustment by the deadline, the employee and employer must have a legally binding right by the deadline to have the adjustment made. The employer is not permitted to pay the employee or provide a benefit intended as a substitute for the correction amount (i.e., the amount the employee is required to repay the employer). |
Limited relief from Sec. 409A penalties if the error is corrected by the end of the employee's second tax year following the year in which the error occurred
(Notice 2007-100, §III.B)
| Correction Method | Details |
|---|---|
| No correction is required. | Sec. 409A penalties:
|
Exhibit 2: An amount is deferred that should not have been deferred, or an amount that should have been distributed from the plan is not distributed
No Sec. 409A penalties if the error is corrected by the last day of the tax year in which the error occurs
(Notice 2007-100, §II.D)
| Correction Method | Details |
|---|---|
| Employer pays the amount to the
employee by the last day of the employee’s tax year in
which the error occurred. Deferred compensation account must be reduced by any positive investment earnings on the erroneous deferral, but only if the employee is an insider (as defined in Exhibit 1). The reduction is allowed, but not required, for employees who are not insiders. Deferred compensation account may be increased for any investment losses, but there is no requirement to do so (even for insiders). The employer may pay reasonable interest to the employee to reflect the time value of money with respect to the delay in payment, but there is no requirement to do so. | The
deadline for adjusting the deferred compensation
account for investment earnings or losses is the last
day of the employee’s tax year in which the error
occurred. If it is impracticable to do so by the
deadline, the employer and employee must have a
legally binding right by the deadline to have the
adjustment made. If the employer pays the employee interest, the interest must be paid or made available by the end of the employee’s tax year in which the error was made. |
Limited relief from Sec. 409A penalties if the error is corrected by the end of the employee's second tax year following the year in which the error occurred
(Notice 2007-100, §III.C)
| Correction Method | Details |
|---|---|
| Sec. 409A penalties:
|
Exhibit 3: Failure to comply with six-month delay rule for distributions made to specifi ed employees of a public company upon separation from service
No correction is available for years in which the employer experienced a substantial financial downturn or otherwise experienced financial or other issues that indicated a significant risk that the employer would not be able to pay the amount deferred when the payment became due.No Sec. 409A penalties if the error is corrected by the last day of the tax year in which the error occurs
(Notice 2007-100, §II.C)
| Correction Method | Details |
|---|---|
| Employee repays the amount to the
employer by the last day of his or her tax year in
which the error occurred. The amount is later distributed in accordance with the plan terms, but in addition to the original six-month delay, it must be delayed by the number of days that elapsed between the date of the erroneous payment and the date the employee repaid the employer. If the employee repayment date is beyond the time when the plan should have made the distribution, the plan must hold the repayment for a period of time equal to the number of days that elapsed between the date of the erroneous payment and the date the employee repaid the employer. | To the extent employment taxes have been erroneously withheld and paid, adjustments should be made under Sec. 6413. |
Limited relief from Sec. 409A penalties if the error is corrected by the end of the employee's second tax year following the year in which the error occurred
(Notice 2007-100, §III.B)The same relief is available as the relief described for the error in Exhibit 1 (i.e., failure to defer an amount for which a deferral election had been made, or distribution of an amount that should not have been distributed).
Exhibit 4: The exercise price of a stock option or stock appreciation right (SAR) is less than the stock's fair market value at date of grant
The correction program is available only if the error in establishing the exercise price at an amount less than the stock's fair market value was due to an unintentional administrative error.No Sec. 409A penalties if the error is corrected by the last day of the tax year in which the error occurs
(Notice 2007-100, §II.E)
| Correction Method | Details |
|---|---|
| Exercise price is reset to an amount equal to or exceeding the stock’s fair market value at date of grant. The reset must occur before the option or SAR is exercised and by the last day of the employee’s tax year in which the option or SAR was granted. | The stock option or SAR
must have met all other requirements for exemption
under Sec. 409A. With respect to the information reporting requirements under the correction program, the employer is not required to provide a statement to the employee. |
There is no further relief if the error is not corrected within the time frame described above.
Editor Notes
G. Edgar Adkins Jr. is a partner in the National Tax Office of Grant Thornton LLP in Washington, DC. Jeffrey Martin is a manager in the National Tax Office of Grant Thornton LLP in Washington, DC. Gary Gross is an executive director with Grant Thornton LLP in Chicago, IL.
