Code Section 409A governs deferred compensation provided through a wide variety of arrangements – ranging from severance to incentive pay to executive and other nonqualified retirement plans. Deferred compensation provided in a manner that does not satisfy the requirements of the statute and related treasury regulations is subject to immediate taxation of the vested benefits, as well as an interest charge and 20% penalty on the taxed benefits. In 2008, the IRS provided a way to correct operational violations, but still there was no way to fix an arrangement that in documentation and design violated Code Section 409A. Recently released IRS Notice 2010-6 provides this long-awaited document correction program, and employers especially should consider taking advantage of the program’s transition relief that allows arrangements corrected by December 31, 2010 to completely avoid 409A income inclusion and penalties.

In addition to providing methods for correcting certain common Code Section 409A violations so that some or all income inclusion and penalties are avoided, the Notice provides guidance on certain commonly used language that will not generally result in a 409A document violation. Generally, arrangements under examination by the IRS are not eligible for correction, and not all document violations can be corrected under the Notice. However, many common unintentional failures can be corrected, including: 

• non-compliant definitions of Code Section 409A permitted payment events,
• impermissible payment events or payment periods,
• failure to include a six-month delay in payments for certain employees of publicly-traded companies, and
• impermissible deferral elections.

 The Notice also provides a grace period for correcting violations under a new deferred compensation arrangement.

To receive the relief offered under the Notice, corrections may require, among other things, identifying and correcting all substantially similar deferred compensation arrangements, eliminating otherwise permissible payment forms, including a portion of the deferred amount in the employee’s income and payment of a penalty either at the time of correction or upon the occurrence of certain events subsequent to the correction, and the employer and the employee reporting certain information relating to the violation to the IRS.

As an added incentive, under the Notice’s transition relief employees may be able to entirely avoid the income inclusion and penalties that will otherwise apply to eligible corrections made after December 31, 2010. Because of this broad relief offered for corrections completed by December 31, 2010, employers who have overlooked or failed to review arrangements for Code Section 409A compliance should seek assistance as soon as possible to take advantage of what is likely to be a final no-penalty opportunity to make documents 409A compliant.

For questions regarding this Alert or other employment or benefits matters, please contact one of our Employment Law or Employee Benefits attorneys.