By Gretchen Harders, Howard Pianko, and Melissa Kass
Like it or not, Code Sec. 409A is here to stay, and just because employers have met the deadline for documentary compliance does not mean that their worries are over. Employers can expect to continue to confront Code Sec. 409A related issues in terms of:
- Code Sec. 409A operational defects;
- failure to amend properly;
- discovering “plans” subject to Code Sec. 409A that have not been amended at all; and
- ongoing preparation of documents with respect to new arrangements or amendments or renewals of existing documents.
This article also highlights the risk and potential penalty exposure to employers who do not meet their withholding and reporting obligations under Code Sec. 409A , and suggests actions employers may want to consider in ensuring Code Sec. 409A compliance.
Code Sec. 409A operational defects
Inevitably, errors in the administration and operation of plans, programs, and arrangements subject to Code Sec. 409A will occur. At that point, the issue is whether the defect may be corrected, or whether Code Sec. 409A’s penalty provisions have been triggered.
The IRS has provided a correction procedure to correct operational failures under Code Sec. 409A. (Notice 2008-113) The correction procedure provides for corrections or penalty tax relief in the following categories: (i) operational failure to defer, impermissible acceleration, excess deferral or six-month delay failure corrected in the same taxable year; (ii) operational failure to defer, impermissible acceleration, excess deferral or six-month delay failure corrected in the taxable year following the year of the failure (applicable only to non-insiders); (iii) operational failures involving amounts under the Code Sec. 402(g) limit that are reported on later than the end of the second taxable year following the year of the failure will have limited tax penalties (in which case the penalty is limited to 20% (no interest) of the incorrect payment); (iv) operational failures not described above if corrected and reported by the end of the second calendar year following the year of the failure (in which case the penalty is limited to 20% (no interest) of the incorrect payment); and (v) special transition rule for any operational failures involving non-insiders that occurred on or before December 31, 2007 (or an early payment that occurred where the original due date was on or before December 31, 2009) if corrected by December 31, 2009.
This correction program provides for relief for failures to comply with the six-month delay rule under Code Sec. 409A(a)(2)(B)(i), which requires a delay of six months for payments of deferred compensation payable to certain specified employees (i.e., generally the top 50 paid employees) upon the employee’s separation from service. This is a welcome clarification. However, correction without penalty is available only if the amount incorrectly paid is repaid to the employer. Recovering a payment from an employee, especially from a terminated employee, is not always easy to accomplish and may even be impracticable.
If there is no available correction for an operational failure, the failure may need to be reported as a violation of Code Sec. 409A. The IRS has issued guidance regarding the calculation of amounts includible in income under Code Sec. 409A, and the withholding and reporting of those amounts for the 2008 tax year. (Notice 2008-115) If there was a violation of Code Sec. 409A in 2008, the amount includible would be reported as wages under box 1 of Form W-2 (box 7 of Form 1099-MISC), as well as separately identified as a Code Sec. 409A amount in box 12, Code Z of Form W-2 (box 15b of Form 1099-MISC). The includible amounts are treated as supplemental wages for withholding purposes. This guidance continues in effect for 2009 until superseding guidance is issued.
In addition, Prop Reg § 1.409A-4 sets forth rules for determining how to report violations under Code Sec. 409A. Prop Reg §1.409A-4 is generally effective for tax years beginning on or before the issuance of final regulations. Generally, amounts are includible in income as of December 31 of the year of the violation, and the amount is determined based on the present value of all amounts payable to the employee on the last day of the taxable year. The rules for determining earnings and present value are complex. Comments with respect to the proposed regulations were requested by March 9, 2009.
Failure to amend properly
There will be some employers who find one or more plans or arrangements that were not amended correctly to comply with Code Sec. 409A. The employer will need to assess whether and to what extent a violation will need to be reported. To the extent the amendment was not clearly incorrect under Code Sec. 409A guidance, a reasonable good faith interpretation of Code Sec. 409A may be helpful in providing a basis for a clarifying amendment.
To the extent payments under a plan are subject to a substantial risk of forfeiture, Prop Reg § 1.409A-4(a)(1) and (a)(2) on reporting and withholding suggests that the agreement may be amended again, provided the substantial risk of forfeiture does not lapse during the same tax year. Thus, there appears to be authority for the proposition that a plan or agreement may be amended in 2009 to comply with Code Sec. 409A with respect to any benefits or payments that are subject to a substantial risk of forfeiture in 2009. As Prop Reg § 1.409A-4(a)(1)(ii)(A) provides that a failure applies on a tax year basis, and does not necessarily carry over to subsequent tax years, this approach might be available as a corrective method under the appropriate facts. Another consideration is that an amendment may limit penalty exposure in subsequent tax years.
Under the Code Sec. 409A correction procedure described above, the IRS had requested comments on whether and to what extent to issue corrective guidance for documentary failures. (Notice 2008-113) However, no such guidance has been issued to date, and it is not clear whether the correction program will be expanded to include documentary failures. Informally, the IRS has expressed concern about the difficulty of crafting a correction procedure permitting the remediation of a documentary failure without allowing for loopholes to avoid compliance.
Nevertheless, as stated above, under certain situations, an amendment may be recommended. It appears that employers will have until the end of 2009 and through January 31, 2010, the deadline for issuing Form W-2 and Form 1099 for the 2009 tax year, to determine how to properly report and withhold under Code Sec. 409A. ( Notice 2008-115) This may provide some additional time this year before decisions need to be made.
Discovering “plans” subject to Code Sec. 409A that have not been amended at all
If a plan was not amended to comply with Code Sec. 409A by December 31, 2008, the plan technically would have a documentary failure under Code Sec. 409A on January 1, 2009. The violation would apply for the 2009 tax year and would need to be reported on the 2009 Form W-2 (or 2009 Form 1099).
Even in that situation, Prop Reg § 1.409A-4 provides a basis for bringing plans, programs, and arrangements into documentary compliance with Code Sec. 409A in 2009 if the benefit being provided is subject to a substantial risk of forfeiture in 2009. If the substantial risk of forfeiture lapses or is scheduled to lapse in 2009, presumably there would be a documentary failure of the vested amount.
As discussed above, the IRS had asked for comments on whether the correction procedures should provide for correction of documentary failures. (Notice 2008-113) In the absence of any future corrective relief of documentary failures, amounts that are not subject to a substantial risk of forfeiture and for which there is no available correction procedure will need to be reported as a violation of Code Sec. 409A. The employer will need to identify the amount, using box 12, Code Z, of Form W-2 (or box 15b of Form 1099), and the affected employee will be responsible for paying any penalties to the IRS.
Ongoing preparation of documents with respect to new arrangements or amendments or renewals of existing documents
Employers need to establish, either internally or with outside counsel, internal procedures and controls to ensure that ongoing arrangements subject to Code Sec. 409A are in compliance with the statute. In particular, attention should be paid to: (i) employment, severance, and change-of-control agreements; (ii) bonus and incentive compensation; (iii) equity compensation adjustments or extensions; and (iv) rabbi trust funding.
The extension or renewal of employment agreements, severance agreements, and change-of-control agreements should be carefully reviewed. To meet the exceptions for payment of severance, the short-term deferral exception under Reg. § 1.409A-1(b)(4), or the separation pay plan exception under Reg. § 1.409A-1(b)(9), the termination must constitute an involuntary separation from service within the meaning of Reg. § 1.409A-1(n). Any entitlement to severance that is triggered by a non-renewal might not be considered a payment upon involuntary separation from service depending on the facts and circumstances related to the separation from service. The relinquishment of rights to payments under the original employment agreement also raises substitution issues under Reg. § 1.409A-3(f) if additional rights are provided under the new employment agreement. When extending or renewing an employment agreement, the substitution rules should be carefully considered, as they run counter to the general business practices for renegotiating compensation terms.
The substitution rules under Code Sec. 409A and Reg. § 1.409A-3(f) also should be considered to the extent employees forego bonus compensation. Any legally binding rights to make up to the employee for the lost compensation will need to be reviewed as a potential impermissible deferral. Any payments proximate or related to the original bonus compensation may be presumed to be a substitution of deferred compensation (and arguably an impermissible deferral).
Any type of equity repricing, adjustments, or extensions should be carefully reviewed for compliance under Code Sec. 409A.
Employers should be aware of the restrictions on transferring or setting aside assets under Code Sec. 409A(b) during the time in which there is a change in the employer’s financial health. For instance, the Code Sec. 409A(b)(3) restrictions apply to employers with a defined benefit plan in “at risk” status under the Pension Protection Act of 2006. If a member of the employer’s controlled group sponsors a frozen defined benefit plan that has had a significant drop in the value of its assets, there could be an adverse tax impact on any rabbi trust or other vehicle that receives assets in respect of deferred compensation.
Risk Exposure: Employer Liability for Reporting and Withholding Penalties
Though the employee has the ultimate responsibility to pay excise taxes under Code Sec. 409A, employers must properly report and withhold the compensation paid to employees. If an employer fails to report an operational or documentary failure under Code Sec. 409A, the employer may be subject to penalties for failure to properly report and withhold on Form W-2 and Form 941, which are set forth under Code Sec. 6651, Code Sec. 6656, and Code Sec. 6662, and related sections.
Code Sec. 6651(a)(1) and (2) set forth the penalties for a failure to file a tax return (5% per month) or a failure to pay tax (0.5% per month of the amount of the tax not exceeding 25% in the aggregate). Code Sec. 6656 imposes an additional 10% penalty on the failure to make required tax deposits with government depositories, if the delay is for more than 15 days. Code Sec. 6662 provides for accuracy-related penalties on underpayments that are based on negligence or a disregard of the rules or regulations in an amount equal to 20% of the underpayment (or 40% if the underpayment was attributable to a gross valuation misstatement). Code Sec. 6663 provides for penalties on underpayments based on fraud, equal to 75% of the unpaid taxes. In addition, the IRS may impose trust fund recovery penalties for a willful failure to deposit FICA and Medicare taxes, equal to 100% of unpaid taxes.
Code Sec. 6721 and Code Sec. 6722 provide additional penalties for an employer’s failure to file a correct information return or a correct payee statement. Each corrected return may be filed with a $50 penalty. However, if the failure to file a correct information return was due to intentional disregard, the penalty is equal to 10% of the aggregate amount of the items required to be reported correctly.
If there is a failure under Code Sec. 409A in 2009, and the amount is not properly reported by the employer in income for 2009, the penalties for failure to properly withhold and report may apply. If the supplemental wage withholding rate of 25% applies and the failure to pay tax covers a period of 18 months, the amount of tax involved would be 25% of the amount includible in income and the Code Sec. 6651(a)(2) penalty would be 9% of the amount of tax. An additional tax for underpayment of 10% on the amount of tax also may apply under Code Sec. 6656, increasing the penalties to 19% of the amount of tax. There is also a $50 penalty to file corrected Forms 941 and Form W-2. If the failure to report is due to negligence, an additional penalty of 20% of the amount of tax could be imposed under Code Sec. 6662, bringing the penalty to 39% of the amount of the tax. Assuming these penalties apply, the total estimated cost to the employer is 25% of the deferred amount, plus an additional 9.75% penalty tax on the deferred amount.
If the failure was due to negligence or intentional disregard, the penalties increase. For example, assume a payment was made to an executive in violation of Code Sec. 409A in 2009, and the employer knew or should have known that the payment should have been reported as a violation under Code Sec. 409A. Although arguably there would be no underpayment or failure to pay tax if the amount is included as wages on the employee’s Form W-2, the employer could be assessed penalties for a failure to file a corrected return. Given that knowledge to the employer and the employee could be inferred, the failure to file a corrected return may be due to intentional disregard under Code Sec. 6721 and Code Sec. 6722, imposing a 10% penalty on the employer of the amount required to be reported correctly, or under Code Sec. 6662, imposing a 20% penalty on the employee with respect to the underpayment. This could result in a tax of up to 20% on the entire amount of deferred compensation.
Regardless of the nature of the failure, the employee is likely to argue that any penalties imposed on the employee under Code Sec. 409A (i.e., 20% plus interest) was the fault of the employer, and should be paid by the employer. As Code Sec. 409A permits the gross-up of the excise tax penalties, the employee “ask” is quite likely to be for a full tax gross-up.
Actions: What Should Employers do Now?
As a matter of managing risk, employers should allocate responsibility to designated officers or committees to ensure Code Sec. 409A compliance. It also is important to develop guidance documents and train the personnel that is responsible for administering the affected plans and the delivery and execution of any documents covered by Code Sec. 409A. Having a process and procedure for identifying potential violations, reporting any necessary taxes, and determining how to handle reporting violations could be helpful in minimizing risk.
In particular, employers who previously adopted form amendments intended to be Code Sec. 409A compliant, but which were not adapted to individual arrangements, should revisit this approach to documentary compliance. Further, any previously approved approach or policy directing a designated person(s), committee, or entity to take the necessary action to effect Code Sec. 409A compliance should be revisited to determine if additional authority is required to identify and correct operational or documentary failures. It is not clear whether the adoption of a “one-size-fits-all” amendment or policy will satisfy the documentary and operational requirements of Code Sec. 409A.
Finally, with respect to not-for-profit employers, proposed regulations are anticipated under Code Sec. 457(f) in which the substantial risk of forfeiture rules under Code Sec. 457(f) likely will be made more consistent with Code Sec. 409A. If amendments may be made with respect to benefits that are subject to a substantial risk of forfeiture, the rules for substantial risk of forfeiture under Code Sec. 457(f) may in practice overtake Code Sec. 409A.
Gretchen Harders is an attorney in Epstein Becker & Green, P.C.’s Employee Benefits Group.