In December, the Internal Revenue Service published additional guidance on deferred compensation under Section 409A of the Internal Revenue Code, including Notice 2008-113 providing for correction of certain operational failures of deferred compensation arrangements and proposed regulations addressing income inclusion.
Notice 2008-113 provides limited relief for certain Section 409A operational failures for periods beginning on and after January 1, 2009. In order to rely on this relief, the failure must be inadvertent and unintentional, and the employer must take reasonable steps to avoid recurrence. An employer that uses this guidance to correct a failure must attach a statement to its tax return and must provide information to affected employees, which they also must attach to their tax returns.
Correction is available for payments mistakenly made before they are due as well as for failures to defer; failure to apply the 6-month delay to specified employees of a public company; deferrals in excess of the amount permitted by a plan or a deferral election; and erroneously setting the exercise price of a stock option at an amount less than the fair market value of the underlying stock on the date of grant. Ideally, a failure should be corrected during the same taxable year in which it occurs but in some cases may be corrected in the next taxable year. Correction may require repayment by the employee, additional income taxes, and adjustment of federal employment and income taxes paid. In cases where an employee must repay a distribution in order to correct a failure, the employer may not reimburse the employee or provide other benefits as a substitute for the repayment.
The proposed regulations will not be effective until after they are finalized, although the IRS is expected to publish interim guidance allowing limited reliance before then. They address calculation of amounts includible in income where a deferred compensation arrangement fails to satisfy the constructive receipt requirements of Section 409A. They take a year-by-year approach, requiring inclusion in income during the year of a failure of all amounts deferred under the plan during such year and all previous years to the extent that such amounts are not subject to a substantial risk of forfeiture and have not already been included in income. Such amounts are determined as of the last day of an employee’s taxable year, regardless of when the failure occurred during the year. The regulations provide detailed methods for calculating the total amount deferred under different types of plans and different payment circumstances as well as methods for determining the amount subject to the additional 20% income tax and how to calculate the premium interest taxes. They also clarify that both of these taxes are income taxes rather than nondeductible excise taxes.
Employers should continue to do their best to operate deferred compensation arrangements properly according to their terms. However, Notice 2008-113 provides valuable guidance for cases when correction is required.