On December 5, 2008, Treasury and the IRS issued proposed regulations addressing the calculation of amounts includible in income and additional taxes imposed under Sec. 409A(a) (REG-148326-05). The regulations are proposed to be generally applicable for tax years beginning on or after the issuance of the final regulations. Taxpayers may rely on these proposed regulations only to the extent provided in Notice 2008-115. That notice indicates that, until Treasury and the IRS issue further guidance, compliance with the provisions of the proposed regulations with respect to the calculation of the amount includible in income under Sec. 409A(a) and the calculation of the additional taxes under Sec. 409A will be treated as compliance with the requirements of the notice.
These proposed regulations do not address the calculation of income inclusion for violations of requirements of Sec. 409A(b), the rules relating to funding. Treasury and the IRS anticipate issuing interim guidance for tax years beginning after January 1, 2007, to address the calculation of income inclusion under Sec. 409A(b) and the application of federal income tax withholding requirements to such amounts.
Year-by-Year Approach
Sec. 409A generally provides that amounts deferred under a nonqualified deferred compensation plan are includible in income unless certain requirements are satisfied. The proposed regulations interpret this rule to provide that failures to comply with Sec. 409A(a) apply to amounts deferred under a plan in the year in which the failure occurs and all previous tax years, to the extent such amounts are not subject to a substantial risk of forfeiture and have not previously been included in income.
As a result, each tax year is analyzed independently as to whether there is a failure. Amounts associated with a failure are required to be included in income for that year, with applicable tax paid. A failure in one year does not, however, continue to taint amounts deferred under the plan in a subsequent year in which there is no failure. A further consequence is that amounts are includible in income in the year of failure. The proposed regulations do not provide taxpayers with a mechanism for current inclusion of income related to a failure from a prior year.
Determination of Amount Deferred
Under the proposed regulations, the amount of income includible for failure to satisfy Sec. 409A(a) is based upon the total amount deferred under the plan for the service provider’s tax year and all preceding tax years, less the portion of the total amount deferred for the tax year that either is unvested or has been previously included in income. In calculating these amounts, the plan aggregation rules apply.
Calculating total amount deferred as of the last day of the tax year: The total amount deferred is determined as of the last day of the service provider’s tax year and is equal to the present value of future payments to which the service provider has a legally binding right under the plan as of that date. In addition, any payments of deferred amounts to, or on behalf of, the service provider during that tax year are added back to the total amount deferred. Notional earnings or losses and additional amounts deferred during the year are simply netted against one another in determining the value as of the last day of the tax year.
Because the determination is as of the last day of the year, the timing of actions during the year does not make a difference under the proposed regulations. For example, it is not relevant whether a distribution is made prior to the occurrence of the operational failure; because it occurred during the tax year of the failure, it is added into the total amount deferred as of the end of the year. Similarly, it is not relevant that an amount was deferred under the plan after the occurrence of an operational failure; it is also taken into account as part of the total amount deferred as of the end of the year.
Calculating total amount deferred— general principles: Generally, the total amount deferred is the present value as of the last day of the tax year, determined using reasonable actuarial assumptions and methods. If the assumption or method used is not reasonable, as determined by the Service, the total amount deferred is determined using the applicable federal rate (based on annual compounding for the last month of the tax year for which the income inclusion amount is being determined) and, if applicable, the appropriate Sec. 417(e) mortality table.
The regulations also provide general rules for determining the present value of payments for the following:
- Payment triggers based on events;
- Alternative times and forms of payment;
- Formula amounts; and
- Payment restrictions.
Calculating total amount deferred— specific rules: The regulations also provide rules for determining the amount deferred under specific arrangements. The general rules described above apply in conjunction with the following rules for specific arrangements:
- Account balance plans;
- Stock rights;
- Stock rights;
- Separation pay arrangements;
- Reimbursement and in-kind benefit arrangements;
- Split-dollar life insurance arrangements;
- Foreign arrangements; and
- Other plans.
Calculating unvested amounts and amounts previously included in income: The unvested portion of the total amount deferred for a tax year is determined as of the last day of the tax year, and such amounts are not taken into account in the calculation of the total amount deferred. Amounts that vest during the year in which the failure occurred are treated as vested for purposes of Sec. 409A(a), regardless of whether vesting occurs before or after the failure, and thus are taken into account in the calculation.
In addition, amounts that have previously been included in income are excluded from the total amount deferred. Consistent with the overall approach of analyzing each year independently, the proposed regulations provide that amounts are considered previously included in income only if the service provider included the amount in income under an applicable provision of the Code for a previous tax year, including on an original or amended return, as a result of IRS examination or a final decision of a court of competent jurisdiction. The amount previously included in income is reduced to reflect any payments made during the tax year because these amounts also reduce the total amount deferred after the year of distribution. Other adjustments are also provided.
For failures that occur in multiple years, each year is analyzed independently to determine if amounts were includible in income. As a result, amounts must be included in income for each year in which a failure occurs. A failure that occurs in multiple years is not corrected if amounts are included in income only for the last year in which the failure occurred.
Determination of Additional 20% and Premium Interest Taxess
The amount includible in income is the difference between the total amount deferred less the sum of the unvested amounts and amounts previously included in income. In addition, this amount is subject to the additional 20% and premium interest taxes. The additional 20% and premium interest taxes are additional income taxes, subject to the rules governing assessment, collection, and payment of income tax. They are not excise taxes, and the premium interest tax is not interest.
The proposed regulations provide guidance on how to calculate the premium interest tax. That tax is applied to the amounts required to be included in income under Sec. 409A(a) for the tax year that were not first subject to a substantial risk of forfeiture in a previous year. The premium interest tax is determined as the amount of interest at the underpayment rate (established under Sec. 6621) plus 1% on the underpayment that would have occurred had the deferred compensation been includible in gross income for the tax year in which the amounts were first deferred or vested. The proposed regulations provide stepby- step calculations to determine premium interest, which tends to reduce the amount subject to the premium interest tax.
Treasury and the IRS have indicated they understand that the premium interest tax calculation provided in the regulations may be cumbersome. As a result, they are considering safe-harbor calculation methods for that tax.
Treatment of Payments and Forfeitures After Amounts Are Included in Income
The proposed regulations state that if a service provider includes an amount in income under Sec. 409A, the service provider will have a deemed basis in that amount, so the amount is not later subject to tax. As a result, if an amount under a plan would be includible in income under a Code section other than Sec. 409A, the amount previously included in income would be immediately applied to the amount paid under the plan. The service provider cannot elect the extent to which amounts previously included in income will be applied. Earnings on amounts included in income and previously included amounts may continue to be subject to Sec. 409A. The Sec. 409A plan aggregation rules apply.
In addition, if a service provider has included deferred amounts in income under Sec. 409A but actually receives less than the amount included in income, the service provider may take a deduction equal to the amount included in income, less amounts allocated to previously included amounts. This deduction is a miscellaneous itemized deduction subject to the 2% floor and is not deductible for AMT. For these purposes, a deferred amount is treated as permanently lost if the service provider’s right to payment becomes wholly worthless during the tax year. A mere diminution in the deferred amount due to deemed investment loss, actuarial reduction, or other decreases in the deferred amount is not treated as a permanent forfeiture or loss if the service provider retains the right to the amount deferred under the plan. The plan aggregation rules apply. If a service provider is entitled to a deduction, to the extent the service recipient has benefited from a deduction or the inclusion in the service provider’s income, the service recipient may be required to recognize income under the tax benefit rule and Sec. 111 or make other appropriate adjustments.
Reporting and Wage Withholding Under Sec. 409A
On December 10, 2008, the Service released Notice 2008-115, interim guidance concerning the reporting and wage withholding requirements for nonqualified deferred compensation under Sec. 409A. The notice is effective for calendar year 2008 and will remain in effect for subsequent calendar years until Treasury and the IRS issue further guidance.
Employer Reporting and Withholding Provisions
For employers, code Y reporting in box 12 of Form W-2 is not required for 2008 or any future year until further notice. Likewise, a payor is not required to report deferred amounts in box 15a of Form 1099-MISC.
In general, the amount includible in gross income under Sec. 409A(a) and required to be reported by the employer on Form W-2 in box 1 and in box 12 using code Z, or by the payor on Form 1099-MISC in boxes 7 and 15b, equals the portion of the total amount deferred under the plan that, as of December 31 of the applicable calendar year, is not subject to a substantial risk of forfeiture and has not been included in income in a previous year, plus any amounts of deferred compensation paid or made available to the service provider under the plan during the applicable calendar year.
The notice provides specific guidance for account balance plans, reasonable ascertainable amounts under nonaccount balance plans, and stock rights. For other deferred amounts, a reasonable, goodfaith method must be applied in a reasonable, good-faith manner.
An employer that complies with this notice will not be liable for additional income tax withholding or penalties or be required to file a subsequent corrected information return or furnish a corrected payee statement as a result of future published guidance on the calculation of amounts includible in gross income under Sec. 409A.
Service Provider Requirements for Amounts Includible in Gross Income
The same standards apply to a service provider as apply to an employer when calculating the amount required to be reported as income under Sec. 409A, except that an amount is treated as previously included in income only if the amount has been included in the service provider’s income in a previous tax year (regardless of whether reported on a Form W-2 or Form 1099-MISC).
Whether a service provider has complied with the notice’s requirements is determined independently of whether the employer has complied with the notice’s requirements. Thus, the IRS may assert additional income taxes and penalties under Secs. 6651, 6654, and 6662 if it is determined that the amount of taxes reported and paid for calendar year 2008 was underreported or underpaid.
IRS Provides Limited Relief for Certain Sec. 409A Operational Failures
On December 3, 2007, the IRS issued Notice 2007-100, providing relief for certain Sec. 409A operational failures and requesting comments on correction under Sec. 409A. On December 5, 2008, Notice 2008-113 was issued, updating and, for periods beginning on or after January 1, 2009, replacing Notice 2007- 100.
Notice 2008-113 addresses the eligibility and types of failures for which correction may be made, during either the same, subsequent, or second tax year after the year in which the failure occurred. The relief is in addition to any other action that would otherwise be permissible under generally applicable tax principles and any adjustments or corrections that may be available under Sec. 409A transition relief, which for the most part expired on December 31, 2008.
Basic Requirements for Notice 2008-113 Reliance
Notice 2008-113 applies only to inadvertent and unintentional failures in the operation of a plan that otherwise complies with Sec. 409A. In addition, the service recipient must take commercially reasonable steps to avoid recurrence of the failure. In particular, if the same or a substantially similar failure has happened before, relief is available for tax years beginning after December 31, 2009, only if the service recipient can demonstrate that it had taken steps to ensure that the failure would not recur and that the failure occurred despite such efforts.
In addition, in order to correct a failure in a year after the year in which the failure occurred, the service provider must not be under examination with respect to the plan. Certain corrections are not available during years in which the service recipient experiences a substantial financial downturn or there is other indication of a significant risk that the service recipient would not be able to pay the amount deferred when due.
In some cases, the ability to correct depends on whether the service provider is an “insider,” which is defined as a director, officer, or 10% owner of a corporation, or analogous persons for noncorporate service recipients.
Notice 2008-113 generally requires service recipients who rely on it to attach a statement to their tax return explaining their reliance and to provide information to affected service providers (other than for correcting discounted options and stock appreciation rights). Service providers are required to attach this information to their federal income tax returns.
The amount of time between failure and correction, the status of the service provider as an insider, and the amount involved will determine:
- The extent to which correction is available;
- Whether income inclusion, withholding, and reporting are required (they are generally required only in circumstances where the failure is not corrected before the end of the year in which it occurred); and
- Whether attributable interest, gains, and losses will be required, permitted, or prohibited.
Available Correction Methods
If all of the foregoing eligibility requirements are met, the following corrections are available for the specified operational failure:
Early payments and failed deferrals: Early payments are defined as amounts deferred in a prior year that should be paid in a future year but are mistakenly paid or made available during the current year. Early payments do not include payments that fail to comply with the six-month delay rule for specified employees or current-year amounts that should have been deferred but were paid currently.
For early payments that are identified in the year paid, Notice 2008-113 allows early payments to be repaid by the end of the service provider’s tax year for distribution as otherwise provided by the deferred compensation arrangement. This can be done through actual repayment, through the service recipient’s retention of other amounts payable, or over a 24- month period, assuming financial need.
In the case of a noninsider, correction may also be made in the year immediately following the year in which the failure occurred.
Failure to delay distribution of deferred compensation: A failure to delay a distribution is defined as a payment made more than 30 days prior to the distribution date as otherwise defined under the plan or payment of an amount to a specified employee within six months after separation from service.
The service provider is required to repay the early distribution, subject to an agreement that the service recipient will make the distribution as provided. If repayment is made prior to the date on which payment should have been made, the service provider must wait additional time after the correct payment date equal to the number of days it held the erroneous payment. If repayment is made subsequent to the date on which payment should have been made, the service provider must wait additional time after the original payment date equal to the number of days it held the erroneous payment plus the original waiting period under the plan or applicable guidance.
If a failure to delay relates to a payment to a noninsider, it may be corrected by repaying the entire amount by the end of the year immediately following the year in which the failure occurred. After the repayment, the service provider must have a legally binding right to receive such amount on a date after the date of the repayment equal to the amount of days between the date the erroneous payment was made and the date it should have been made.
Excess deferrals: Excess deferrals are deferrals in excess of the amount provided for under the plan or election. The excess amount deferred must be distributed by the end of the service provider’s current tax year, with an adjustment made to the amount to which the service provider has a legally binding right at the end of the year (e.g., a reduction in the account balance).
Excess deferrals by a noninsider are also permitted to be corrected through a distribution of the excess deferral by the end of the year immediately following the year in which the failure occurred. There must be a related adjustment to the amount to which the service provider has a legally binding right at the end of the year (e.g., a reduction in the account balance).
Discounted stock options and stock appreciation rights: A stock option or stock appreciation right (stock right) that constitutes nonqualified deferred compensation solely because the exercise price was erroneously set at an amount less than the fair market value of the underlying stock on the date of grant is a discounted stock right eligible for correction.
During the year of grant, the exercise price may be reset to an amount not less than the fair market value on the date of grant prior to the date of exercise or the last day of the service provider’s tax year in which the grant was made. Correction can be made to outstanding stock rights even if other rights in the same grant were already exercised and are therefore ineligible for correction. Notice 2008- 113 provides no correction method for discounted options after exercise.
For grants made to noninsiders, the exercise price of a discounted stock right may also be reset prior to the earlier of the exercise date or the end of the service provider’s year immediately following the year in which the stock right was granted.
Relief for Failures Involving Limited Amounts
In addition to the correction methods discussed above, Notice 2008-113 provides relief from the taxes that would be incurred for failures involving limited amounts. This relief is available only to the extent that all steps are taken by the end of the second tax year after the service provider’s tax year in which the failure occurred, but it is available only for early payment, failed deferrals, failure to delay distributions, and excess deferrals.
Relief for Certain Other Operational Failures
Notice 2008-113 provides further relief in some circumstances in which correction is made by the end of the second tax year after the tax year in which the failure occurs by limiting the extent to which the premium interest tax is applicable. This relief is restricted to correction of early payments and failed deferrals, failure to delay distributions, and excess deferrals.
Special Transition Relief for Noninsiders
In general, operational failures that occurred prior to December 31, 2007, if otherwise eligible for correction under the methodologies discussed above for correction in the year after the year in which the failure occurred (other than discounted stock rights), are eligible for correction notwithstanding the fact that the time limit for correction has passed. For this purpose, the service provider’s tax year ending in 2009 is deemed to be the year following the year in which the failure occurred.
A Modification to the IRS’s No-Rule Policy on Sec. 409A Issues
In January 2007, the IRS issued its annual revenue procedure on rulings and determinations, indicating that it would not rule on the tax consequences of arrangements described in Sec. 409A. This blanket no-rule policy was modified by Rev. Proc. 2008-61, which indicates that the IRS will continue not to consider the tax consequences of the establishment, operation, or participation in a plan described in Sec. 409A, but will rule on other very specific tax law provisions, such as estate and gift taxes and FICA.
EditorNotes
Jeff Kummer is director of tax policy at Deloitte Tax LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
For additional information about these items, contact Mr. Kummer at (202) 220-2148 or jkummer@deloitte.com.
