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IRS Defers Section 409A Reporting Obligations

Sponsors of nonqualified deferred compensation plans are now beginning to understand the substantive constraints imposed on such plans by Tax Code Section 409A, which was enacted as part of the American Jobs Creation Act of 2004 (AJCA). At the same time, however, sponsors and administrators of nonqualified plans have been struggling to understand and apply the AJCA’s new tax reporting obligations.

These reporting requirements took effect with the 2005 tax year – for which W-2s and 1099s will be due this month. Recognizing the many practical hurdles to compliance with these reporting requirements, however, the IRS has now granted a one-year deferral in their application.

Among other things, the AJCA requires that the amount of any nonqualified deferred compensation be reported on an employee’s W-2 during both the year of deferral and the year of payment. Moreover, if a nonqualified plan violates any of the substantive provisions of Section 409A, the deferred amounts (to the extent vested) will be taxable even prior to their receipt. Such 409A-taxable amounts must be separately reported on a W-2. Similar tax reporting requirements apply to independent contractors, but with deferred amounts reportable on Form 1099.

In Notice 2005-94, the IRS has suspended these new reporting obligations with respect to the 2005 tax year. Thus, sponsors of nonqualified deferred compensation plans need not take these new requirements into account when issuing W-2s or 1099s in January of 2006.

The IRS cautions, however, that future guidance may require sponsors of nonqualified plans to issue corrected W-2s or 1099s as a way of properly reporting nonqualified deferred amounts for 2005. Sponsors should thus attempt to gather and maintain the information they would need in order to issue such corrected tax statements.

Moreover, this guidance does not shield employees or independent contractors from any tax liability they might incur as a result of a violation of Section 409A during 2005. The IRS’ sole concession on this point is to note that such service providers will be able to avoid tax penalties (though not interest assessments) if they pay any additional tax due as a result of such a violation within a specified period of time following the issuance of additional guidance on this subject.

Importantly, the IRS Notice does not suspend these new tax reporting obligations for the 2006 tax year. While the IRS has promised further guidance on this and related subjects (such as how to calculate the deferred amounts to be included in taxable income upon a Section 409A violation), the massive scope of the compliance effort is such that sponsors of nonqualified plans would be well-advised to begin making the necessary system adjustments immediately.