Many hospital administrators and doctors have severance or other deferred compensation arrangements. Unfortunately, many of these arrangements may inadvertently violate something called Section 409A of the Internal Revenue Code, because they were created before 409A came into existence or before its nuances were fully understood. While some deferred compensation arrangements are considered grandfathered and not subject to 409A, and others could have been amended to comply with 409A prior to January 1, 2009, there was no accepted method to correct 409A drafting mistakes since then, until now.
The Internal Revenue Service recently released a corrections program for certain nonqualified deferred compensation document failures under 409A (Notice 2010-6). Some of the more common document failures can be voluntarily corrected pursuant to this program to avoid (or reduce) current income inclusion and excise and interest taxes. In fact, corrections made in 2010 in accordance with the Notice will not have any adverse tax consequences, and plans will be treated as if they were corrected on 1/1/09, the first day plans had to be in documentary compliance with 409A.
The corrections program is not a means to correct all document failures, and each deferred compensation arrangement should be carefully reviewed to determine what, if any, corrections should be made by year-end.
The general premise of 409A is that all amounts of deferred compensation are currently includible in income and subject to excise and interest taxes unless certain requirements are met. Even inadvertent and seemingly innocuous failures to comply with the technical requirements of 409A, either in form or operation, can have severe tax consequences to the participant.
First, the deferred compensation is subject to immediate inclusion in gross income for purposes of calculating the participant's federal income taxes. Further, the participant is subject to a 20% excise tax and an underpayment interest tax on the deferred compensation.
B. Covered Failures
Incorrectly Defined Terms. Plans that contain permissible payment events under 409A, such as Separation from Service, Change in Control, and Disability, but do not define them correctly, may be corrected in accordance with Notice 2010-6. With the exception of Disability, incorrectly defined terms must be corrected before the event occurs.
Payment Periods Longer than 90 Days Following Payment Event. 409A requires that if a plan specifies a single payment following a payment event, the payment must be within the same taxable year or be within a specified period of not more than 90 days. Plans may be amended prior to the event to provide that the payment period following a permissible payment event complies.
Releases. Many plans condition the receipt of deferred compensation upon the participant's execution, and non-revocation, of a release of claims, noncompetition agreement, or nonsolicitation agreement. The IRS views these provisions as problematic, because they may allow the participant to accelerate or delay payment, and, therefore, income inclusion, by deciding when to sign the release or agreement. Defective provisions may be corrected before the payment event has occurred to remove any participant discretion as to timing of payments.
Alternative Times and Forms of Payment. 409A does not allow a plan to provide for more than one time, or form, of payment upon the occurrence of one single payment event. If a plan provides for different times, or forms, of payment based on whether the participant's separation from service is voluntary or involuntary, the plan should be amended before the separation from service occurs to make the time and form of payment for a voluntary separation the same as the time and form of payment for an involuntary separation.
If a plan contains multiple times and forms of payment relating to some other event, other than voluntary/involuntary separation from service, the provision may be corrected before the event occurs, and the amendment should generally retain the time and form of payment that will result in (or potentially result in) the latest final payment date.
Impermissible Discretion. Plan provisions that allow the employer to accelerate payments may be removed before such discretion has been exercised. This may include provisions that allow the employer unilaterally to terminate and to liquidate the plan.
Impermissible Reimbursement or In-Kind Benefits. 409A contains specific rules on how reimbursement or in-kind benefits may be provided. In general, the plan must provide that reimbursement or in-kind benefits provided in one year may not affect reimbursement or in-kind benefits to be provided in another taxable year. Provisions that provide for reimbursement or in-kind benefits over a period of time, up to an aggregate amount, should be amended before the payment event to provide that the overall amount eligible for reimbursement or in-kind benefits is allocated pro-rata over the number of years during which the participant would be eligible for reimbursement or in-kind benefits.
Failure to Include 6-Month Delay for Specified Employees. 409A requires plans of public company employers to include a 6-month delay on payments to "Specified Employees." Where necessary, plans can be amended prior to the occurrence of the payment event provided the payment is delayed until the later of 18 months following the date of correction or 6 months following the separation from service.
Impermissible Initial or Subsequent Deferral Election. Initial and subsequent elections to defer compensation must be made by specific deadlines and in accordance with specified rules under 409A. Plan provisions that do not adhere to these requirements may be corrected in accordance with the Notice.
Newly Adopted Plans. A plan can be corrected until the later of the end of the calendar year in which it is adopted, or the 15th day of the 3rd calendar month following the year in which the benefits become vested.
Ambiguous Terms. Notice 2010-6 also provides welcome clarification that the use of certain terms relating to the timing of a payment, such as "as soon as reasonably practicable" or the use an ambiguous definition (or no definition) of a payment event, is not a document failure. For instance, plans commonly use "termination of employment" as a payment event, instead of "separation from service," as defined in 409A. A termination of employment could be interpreted to include events that both would and would not constitute a separation from service under 409A.
Although not a document failure, ambiguous terms increase the likelihood of an operational failure. Notice 2010-6 provides that the plan may be amended at anytime, without tax consequences or reporting, to clarify that the 409A separation from service standard will be used, as long as no payments have been made upon a termination of employment that would also not qualify as a separation from service under 409A. Note, however, that if the Plan contains a 409A "savings clause" that provides that the plan will be interpreted to comply with 409A, the term will not be considered to be ambiguous.
C. Advantage of Correcting in 2010
Although an employer may correct any of the specific failures outlined in the Notice at any time, special transition relief is available for corrections made by 12/31/10. If a permissible correction is made by 12/31/10, the plan is treated as having been corrected on 1/1/09, and any otherwise required income inclusion, including the 20% excise tax, will not apply.
Corrections made on and after 1/1/11 may require, as a condition to being able to correct, that some portion (generally either 50% or 25%) of the deferred compensation be included in the participant's income in the year of correction, and the 20% excise tax be paid on the included amount.
However, the Notice also includes a "one-year tracking" rule that generally provides, if a correction does not impact the operation of the plan for one year after the date of correction, there will be no adverse tax consequences. Where, however, the correction does impact the operation of the plan within one year after the date of correction (that is, the correction prevents a payment that would have been made under the original provision, or the correction causes a payment that would not have been made under the original provision), a reduced portion of the deferred amount must be included in income, and a 20% excise tax on such amount must be paid.
D. Reporting Obligations
Corrections allowed by Notice 2010-6, including those made in 2010, must be reported to the IRS. The employer must prepare, and attach to its corporate federal income tax return, a statement providing certain details related to the correction, as well as provide statements to participants to attach to their federal return for the year in which the correction is made.
E. Uncorrectable Failures
Certain document failures cannot be corrected under Notice 2010-6. These include giving the participant too much discretion, allowing the participant to accelerate a payment in exchange for a lesser payment (commonly referred to as a "haircut" provision), or noncompliant stock rights. Employers also generally cannot correct "linked plans," where the amount deferred, or the time or form of payment, is determined by the payment provisions of one or more other nonqualified or qualified plans, except during a special transition period ending 12/31/11.
Also, to correct under Notice 2010-6, the failure must be "inadvertent and unintentional," and the employer must take "commercially reasonable" steps to identify and to correct consistently all plans with substantially similar failures. Correction is generally not allowed if the participant or the employer is under examination by the IRS for nonqualified deferred compensation. Another condition to correction is that any impermissible payments or non-payments made before the end of 2010 under the defective provisions must be corrected under the operational corrections program previously released in IRS Notice 2008-113.
Compliance with 409A is very complex, and guidance from the IRS is constantly evolving. Employers and participants are well advised to review any arrangements potentially subject to 409A, and correct any defective provisions this year.