December 31, 2010 marks the closing of a window offered by the IRS to self-correct non-qualified deferred compensation programs (NQDC) for failure to comply with Internal Revenue Code Section 409A (409A). Although many employers have reviewed their programs for 409A compliance, some have not and should do so. Let’s briefly look at the issue and what should be done before year end.
NQDC include (but are not nearly limited to) traditional deferral arrangements (such as supplemental retirement plans and voluntary deferred compensation plans); annual and long-term cash incentives; certain equity -based incentives (options, restricted stock, restricted stock units, etc.); employment and severance arrangements; change of control programs; and certain fringe benefits. Some of these arrangements may be exempt from section 409A — if they are properly designed and operated.
NQDC’s must comply with section 409A’s requirements in both form and operation. The form requirements are met only if the written document (and you need a written document) contain certain terms and conditions. If the document did not satisfy 409A’s requirements as of December 31, 2008, the NQDC is deemed to be in violation of section 409A. If the NQDC, even if the document is acceptable, doesn’t actually operate in accordance with 409A, the program is in violation.
The consequences of a section 409A violation are harsh:
- Immediate inclusion by the employee of all unpaid amounts under the program and all similar arrangements (other than grandfathered amounts, if any);
- A 20% penalty tax on the amount described above, payable by the employee; and
- An underpayment interest penalty, payable by the employee, which is retroactive to the year in which the deferred amounts should have been included in income.
So a violation of 409A results in the employee paying tax today on amounts he or she will receive in the future, along with penalties. The IRS has a special audit initiative relating to employment taxes which has 409A as one of its focuses, even though the only penalty the employer faces is significantly disgruntled employees.
In Notice 2010-6, the IRS gives employers the opportunity to revise the NQDC documents to satisfy the requirements of 409A. Plans that are corrected under the notice are treated as if they were corrected on January 1, 2009. If the correction means that an amount should have been paid out between January 1, 2009 and December 31, 2010, Notice 2008-113 will allow corrections of those issues in certain cases.
With all this being said, an employer would be prudent to review all of its compensation program documents to make sure that they are in compliance with 409A; it would also make sense to determine if there are any “unwritten” programs that might be subject to 409A, and have plan documents prepared.
If you have any questions regarding 409A compliance, post a comment below or contact me at 440-449-6800.