Thankfully we are now a few months past December 31, 2008, which was the final deadline for deferred compensation arrangements to be in written compliance with Section 409A.
Now that your plans are in written compliance and you have had time for a breather from Section 409A, it is time to remind you that Section 409A has not disappeared.
To reinforce that point, here is a brief summary of the latest Internal Revenue Service guidance regarding the calculation of taxable income under Section 409A and a correction program for operational failures to comply with Section 409A. Some of this guidance can even be considered favorable to employers and employees!
Income Inclusion and Tax Withholding Guidance
In Notice 2008-115, the IRS provided the rules for reporting and withholding for calendar year 2008. Most importantly, the Notice continues the IRS’ previous practice of not requiring employers to report deferred compensation in Box 12 of Form W-2 using code Y for future years until the IRS issues additional guidance. The IRS does not expect to issue additional guidance until the proposed regulations discussed below are finalized.
The IRS also has issued proposed regulations explaining how to calculate amounts included in income and the additional taxes under Section 409A when there is a violation of Section 409A. There are two key concepts in the proposed regulations.
The first key concept is that a violation of Section 409A relating to unvested amounts will not result in taxable income under Section 409A. This is extremely important, and essentially allows employers a second bite at the apple for Section 409A compliance with regard to unvested amounts. Vested amounts would be taken into income upon a violation of Section 409A and taxed accordingly.
The second key concept is that a violation of Section 409A is not permanent. A violation will result in taxable income for the year of the violation, but does not taint future years if the plan is amended to comply with Section 409A for future years. An employer will need to report taxable income for a compliance failure in one year, but by correcting the failure future taxation can be avoided. This is very good news and a significantly beneficial change from what appeared to be the draconian result of taxation of all past, present and future amounts of deferred compensation upon a violation of Section 409A.
The proposed regulations include significant detail on how to calculate the amount of taxable income under Section 409A, including specific information for different types of plans (e.g., account balance plans, non-account balance plans, stock rights, separation pay, reimbursement and in-kind benefit arrangements, split-dollar plans, foreign arrangements and other plans). If you have a violation of Section 409A, these regulations will need to be analyzed closely to calculate the amount of taxable income and additional taxes under Section 409A.
The IRS has requested comments on the proposed regulations. We will provide you with more information when the final regulations are issued.
In Notice 2008-113, the IRS expanded a previously announced correction program for operational compliance failures. Note that this program covers only operational failures. The IRS has requested comments on a potential document correction program, which would be welcome relief, but at this point there is no such program.
Although the new correction program expands on the previous program, it remains very limited. The program can only be used to correct unintentional and inadvertent operational failures. Correction can only be made through specific methods provided by the IRS in certain limited circumstances, such as:
- Correction of operational failures within the same taxable year as the failure.
- Correction of operational failures for "non-insiders" by the end of the taxable year following the taxable year of the failure.
- A limitation of the amount that can be included in income under Section 409A for failures involving limited amounts ($16,500 for 2009).
The timing, the status of a participant and the amount involved are all relevant to determining what correction methods, if any, are available. If you have an operational failure to comply with Section 409A, please contact us immediately. The sooner a failure is identified the more likely there is a correction method under this program.
The income inclusion regulations and the correction program are the latest IRS guidance on Section 409A, but definitely not the last. Hopefully yet this year we will see final income inclusion regulations and a documentary compliance failure collection program.