As anticipated, the Treasury Department and Internal Revenue Service (“IRS”) released guidance earlier this week (Notice 2007-100), which provides taxpayers with the ability to self-correct or at least obtain limited tax relief in certain situations where a nonqualified deferred compensation arrangement fails to comply in operation with Section 409A of the Internal Revenue Code (“409A”). As discussed in previous articles, failure to comply with 409A requirements results in the automatic inclusion of all amounts deferred under the arrangement, a possible “premium interest tax,” and an additional 20% tax on the included amounts.
This recent guidance first provides transitional relief for failures corrected in the same taxable year in which the failures occur. However, relief is limited to unintentional operational failures (e.g., a failure to follow plan provisions that otherwise comply with 409A and a failure to follow the requirements of 409A because of errors in plan operation). Specifically, the Notice generally allows for avoidance of income inclusion for the following unintentional operational failures that occur and are corrected during the service provider’s same taxable year:
- Failures to properly defer compensation when otherwise required;
- Failures to apply limits on payments of deferred compensation;
- Failures to delay payments in violation of the six-month rule (specified employees of public companies only);
- Failures to properly limit the amount of compensation that is deferred; and
- Failures to set the exercise price of a stock option or stock appreciation right at or above the fair market value of the underlying stock as of the grant date.
The Notice also provides limited transitional relief generally for failures that are not corrected within the same taxable year. Such relief does not avoid income inclusion, but it does limit income inclusion to just the amount involved in the failure without causing 409A’s tax consequences to apply to otherwise-compliant deferred amounts under the same arrangement. However, this relief is limited to relatively small dollar amount failures ($15,500 in 2007). Further, it applies only for certain operational failures occurring in a service provider’s taxable year beginning before 2010, and correction requirements must be met not later than the end of the second calendar year following the year in which the failure occurred.
The Notice includes detailed information and reporting requirements under the various scenarios described above, which are primarily imposed on employers.
Finally, the Notice discusses a potential correction program under consideration by the Treasury Department and IRS, which could include permanent availability of correction guidance under the Notice and could allow relief for larger failures not correct in the same taxable year. Unlike other correction programs, it is anticipated that such program would only entail self-correction.
Because avoidance of income inclusion only occurs if a 409A failure is corrected in the same year as the failure, companies may wish to immediately evaluate whether any failures occurred in 2007, and, if so, seek to correct them pursuant to the Notice by December 31, 2007. Similarly, they may wish to evaluate whether any failures occurred in 2005, and, if so, seek to correct by December 31, 2007, in order to take advantage of the relief providing only limited applicability of 409A.