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IRS Issues Guidance On Correcting Defects In Nonqualified Plan Documents

The American Jobs Creation Act of 2004 changed the landscape of compensation arrangements by adding Section 409A of the Internal Revenue Code, which imposes strict operational and documentation requirements on nonqualified deferred compensation arrangements. Section 409A applies to any plan, agreement, or arrangement that creates (in a given tax year) a legally binding right to compensation that is payable in a later year. Consequently, Section 409A applies to a wide variety of arrangements, including supplemental retirement programs, bonus plans, incentive compensation arrangements, employment agreements, severance agreements, and equity compensation plans.

Generally, a plan or arrangement subject to Section 409A must be in writing, and the plan document must specify the amount deferred (or a formula for determining that amount), the time and form of payment (including, if applicable, a six-month delay for payments to “key” employees of publicly traded companies), and the conditions under which initial and subsequent deferral elections may be made. In addition, the written plan must not permit any impermissible acceleration of payment by either the employer or the employee (a term that includes, for purposes of this article, independent contractors). Failure to comply with Section 409A (in either form or operation) results in (i) immediate taxation of the amounts deferred, (ii) a 20% penalty tax, and (iii) interest (at the federal underpayment rate plus 1%) from the date the employee was first vested in the deferred compensation.

Although Section 409A applies to all amounts deferred or vesting after December 31, 2004, the IRS regulations interpreting and implementing Section 409A did not become fully effective until January 1, 2009. Prior to that date, plans were subject to a “reasonable, good-faith” standard for operational compliance, but were not required to have a fully 409A-compliant plan document. In December of 2008, the IRS issued guidance (Notice 2008-113) describing a program for correcting certain operational defects in nonqualified plans subject to Section 409A. However, until recently, there was no formal program or guidance for correcting plan documents that were not 409A-compliant by the January 1, 2009, deadline.

On January 5, 2010, the IRS issued Notice 2010-6, which provides relief for certain plan document failures under Section 409A if they are properly corrected. The Notice provides “fixes” for many (but not all) such failures. Notice 2010-6 is welcome guidance for both employers and employees because it allows the parties to avoid the harsh tax consequences of a technical 409A failure that may be attributable solely to the inadvertent inclusion of a provision that is contrary to (or the exclusion of a provision that is required by) Section 409A.


Under a special transition rule, certain plan document failures that are corrected by December 31, 2010, will be treated as having been corrected on January 1, 2009 – the first day that plans were required to be in full documentary compliance with Section 409A. Under the transition rule, there is no income inclusion (and no 20% penalty) so long as any operational failures related to the documentary failure are corrected in accordance with IRS Notice 2008-113.

There is also transition relief for corrections made by December 31, 2011, where the document failure involves a payment schedule that is determined by the timing of payments received by the employer (such as payments based on accounts receivable). Moreover, although the documentary correction guidance generally does not apply to employers or employees that are under audit, there is a transition rule that will allow certain defects to be corrected if the audit relates solely to tax periods beginning on or before December 31, 2011.


In order to take advantage of the document correction guidance, several general requirements must be satisfied. First, the failures must be inadvertent and unintentional. Second, the employer must take “commercially reasonable” steps to identify and correct all other plans and arrangements subject to Section 409A with the same or substantially the same documentary failure. Third, neither the employer’s nor the employee’s federal income tax return may be under examination with respect to nonqualified deferred compensation for any taxable year in which the failure existed. Fourth, if required by the specific correction procedure, the employee must include the applicable percentage (generally either 25% or 50%) of the deferred amount as taxable income on his or her tax return, and must pay all applicable taxes, including the 20% penalty (but not the interest penalty), on the amount included in income. Finally, the employer must satisfy certain information and reporting requirements with respect to the failure.


Six general categories of failures may be corrected under Notice 2010-6:

Impermissible Definition of Payment Event. Under Section 409A, amounts deferred may generally be paid only upon (1) a specified date, (2) separation from service, (3) death, (4) disability, (5) change of control, or (6) unforeseeable emergency. Several of these terms have specific definitions under the final 409A regulations. Use of a different definition may result in a Section 409A violation.

Notice 2010-6 permits an employer to replace an impermissible definition with a compliant definition, provided the correction occurs before the date the payment event occurs. However, if the correction affects a distribution under the plan within one year, the affected employee must include in income the applicable percentage (50%, in the event of a defective definition of separation from service; 25% in the event of a defective definition of change of control) of the deferred amount, and must also pay the associated taxes.

Impermissible Payment Periods. The final 409A regulations permit payment during a period that is expressly limited to one tax year, or a period not longer than 90 days after the payment event. Notice 2010-6 permits the employer to amend a plan provision that contains a payment period longer than 90 days, or that conditions payment upon an employee’s action during the payment period (such as execution of a release). If corrected before the date of the payment event, there are no tax consequences If corrected within a reasonable period after the payment event, the employee must include in income 50% of the deferred amount and must pay the applicable 409A taxes.

Other Impermissible Payment Events or Impermissible Discretion. The final 409A regulations permit a plan to provide for different times or forms of payment for each permissible payment event, or to allow for different payment schedules depending on when the payment event occurs. Notice 2010-6 provides relief for plans with impermissible payment events or schedules, and for plans that impermissibly permit employer or employee discretion to change the time or form of payment. If correction is made before the date of the payment event, there are no tax consequences. If, however, the operation of the plan is affected by the correction within one year of the correction, the employee must include in income 50% of the deferred amount and must pay the associated 409A taxes.

Failure to Include the Six-Month Delay Rule. Plans of publicly traded employers must include a provision for a six-month delay in payments to certain “key” employees on account of a separation from service. Notice 2010-6 permits an employer to correct a plan that fails to include such a provision, so long as (i) the correction is made before the key employee’s separation from service, and (ii) the plan is further amended to provide that payment may not be made before the later of 18 months after the correction date or six months after the separation from service. If a key employee has a separation from service within one year of the correction, the employee must include in income (for the year of separation) 50% of the deferred amount and must pay the associated 409A taxes.

Impermissible Deferral Elections. A plan subject to Section 409A must generally provide that any compensation deferral election (by an employee) be made prior to the first day of the calendar year in which the compensation will be earned. Notice 2010-6 permits an employer to correct a plan document that includes an impermissible deferral election procedure. This correction may be made without tax consequences so long as the impermissible provision has not been “applied” by the employee or the employer.

If the provision has already been applied, the employer may correct the plan no later than the end of the second taxable year after the year in which the applicable deadline for making the deferral election occurred. In this case, however, the employer must also correct the “operational” error under IRS Notice 2008-113.

Initial Adoption of New Plan. Notice 2010-6 provides a transition period for document corrections (related to any of the types of errors listed above) that are made shortly after an employer’s adoption of a new plan. The transition period generally ends at the end of the tax year in which the first legally binding right to deferred compensation arose. So long as the document errors are corrected within the transition period — and any associated operational errors are corrected under Notice 2008-113 — the correction may be made without tax consequences.

Guidance Regarding Documentary “Failures”

The Notice also provides guidance as to whether certain plan provisions result in Section 409A failures. Importantly, the Notice provides that certain ambiguous plan terms will not be result in a plan document failure, so long as the plan is otherwise operated in compliance with Section 409A.

For example, the Notice provides that a plan provision providing for payment “as soon as practicable” following a permissible payment event does not, by itself, result in a document failure (as suggested by the final 409A regulations). Similarly, a plan that provides for payment upon “termination of employment” (rather than upon “separation from service,” as defined in the 409A regulations) will not, by itself, result in a document failure — so long as that plan provision has been interpreted, for all periods after 2008, in a manner that is consistent with the 409A definition of separation from service. The Notice also confirms the effectiveness of plan provisions requiring that all ambiguous or undefined terms be interpreted to comply with Section 409A.


Despite all efforts to identify nonqualified deferred compensation arrangements and amend them (by January 1, 2009) to comply with the strict requirements of the final 409A regulations, many employers still have plans or arrangements that do not comply with all of the documentary requirements of Section 409A. For unintentional document failures, the harsh tax consequences of a 409A failure may be avoided by correcting those document defects in accordance with Notice 2010-6.

Because the Notice includes transition relief for failures corrected before 2011 (and limited tax consequences for failures that are corrected before certain events occur), there is now additional incentive for employers to (i) identify all plans or arrangements that may be subject to Section 409A, (ii) review those plans for documentary compliance with Section 409A, and (iii) correct any plan document defects in accordance with the correction procedures set forth in Notice 2010-6 .