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New Section 409A Guidance Alert

February 17, 2009

The Internal Revenue Service and the Department of the Treasury have issued three new pieces of guidance related to Section 409A of the Internal Revenue Code ("Section 409A"). The new guidance includes Proposed Treasury Regulations addressing the calculation of includable income and additional taxes under Section 409A, IRS Notice 2008-113 regarding the correction of certain operational failures, and IRS Notice 2008-115 addressing wage withholding requirements.

Background of Section 409A

Section 409A generally applies to compensation arrangements that provide a legally binding right to a payment in a future year (i.e., applies very broadly to various forms of deferred compensation), unless certain exceptions apply. Violations of Section 409A (failures to comply with either written documentation requirements or the operation of the arrangements) will invoke the following penalties to the service provider (usually the employee): (1) a 20 percent excise tax (in addition to regular federal income taxes), (2) immediate income inclusion (usually, on the date of vesting), and (3) interest on the tax due at an increased rate from the date of vesting. Generally, the employer will have reporting and withholding obligations and will be subject to penalties for any failure to properly satisfy such obligations. If Section 409A penalties are incurred with respect to one type of payment (e.g., a separation payment, equity compensation payment, etc.), these penalties could also apply to payments under other deferred compensation arrangements of the same type in which the service provider participates and that are subject to Section 409A—even if such other deferred compensation arrangements are compliant with Section 409A.

Proposed Treasury Regulations

The new proposed regulations under Section 409A address the calculation of amounts includable in income as a result of failures under Section 409A and the calculation of the additional taxes applicable to such income. The proposed regulations generally apply the adverse tax consequences associated with Section 409A failures only with respect to amounts deferred under the non-qualified deferred compensation plan in the year in which such failure occurs and all previous taxable years, to the extent such amounts are not subject to a substantial risk of forfeiture (i.e., to the extent they are vested) and have not previously been included in income. 

The proposed regulations allow employers to correct plan language which is non-compliant, on a prospective basis, to the extent that the deferred amounts, including previously-deferred amounts, under such plan are subject to a substantial risk of forfeiture at the end of the year of the Section 409A failure. In other words, for calendar years when deferred compensation becomes vested (no longer subject to a substantial risk of forfeiture), non-compliant plan language cannot be corrected.  However, the ability to correct plan language where the amounts deferred are subject to a substantial risk of forfeiture at the end of a year may not be permissible if the facts and circumstances indicate that the employer has a pattern or practice of permitting such non-permissible changes in the time and form of payment with respect to non-vested deferred amounts.

Correction of Operational Errors

IRS Notice 2008-113 provides a correction procedure to address certain operational failures with respect to Section 409A. This notice does not address failures as to written compliance (failures as to form). The types of failures that may be corrected generally include the following: 

(1) correcting discounted stock options and stock appreciation rights by increasing the exercise price to the fair market value of the stock on the date of grant;

(2) excess deferrals;

(3) failed deferrals;

(4) early payments; and

(5) failures involving limited amounts.

The correction must take place in the same taxable year of the failure. Certain corrections, however, may be made in the following taxable year (other than with respect to insiders). Depending on the failure, certain corrections may not be able to be utilized if the employer experiences a substantial financial downturn or there is a risk that the employer will be unable to pay the deferred amount at the time set forth in the plan. A filing with the IRS is usually necessary as part of the correction.

Reporting and Wage Withholding Requirements

IRS Notice 2008-115 provides guidance related to the reporting and wage withholding requirements with respect to Section 409A. The reporting and withholding obligations for Section 409A are generally consistent with the income inclusion calculations under the proposed regulations discussed above.

Action Items

Employers should conduct a regular inventory of their deferred compensation arrangements subject to Section 409A in order to assess whether such arrangements are in compliance in operation and form with the requirements of Section 409A. The sooner that any failure is determined, the greater the likelihood that Section 409A penalties may be mitigated or even eliminated.