IRS Issues Voluntary Correction Program for Section 409A Operational Violations

December 5, 2007

On December 3 the Internal Revenue Service issued Notice 2007-100, which provides a limited voluntary correction program for certain operational violations of Section 409A of the Internal Revenue Code. Under the program, many operational violations can be corrected in the year in which the violation occurs. In addition, relief applies in limited circumstances for operational violations that are corrected in years after they occur. Taxpayers who take advantage of the program receive specified relief from the harsh consequences of a Section 409A violation, which generally include immediate tax of all amounts deferred under the plan (as well as all plans of the same "type" that are aggregated with that plan), a 20% additional tax, and an interest charge.

General Eligibility Requirements. In order for the program to be available with respect to a particular violation, the following requirements generally apply:

  • Only operational violations are eligible for relief. Defects in plan documents cannot be corrected under the program.
  • The operational violation must be unintentional. In addition, the program is not available when an operational failure is egregious or when it is directly or indirectly related to participation in an abusive tax avoidance transaction.
  • The employer/service recipient must take commercially reasonable steps to avoid a recurrence of the operational violation. If the same or a substantially similar operational failure has occurred previously, the relief is not available for any taxable year beginning after December 31, 2008 unless the employer demonstrates that the employer: had established practices and procedures reasonably designed to ensure that such an operational failure would not recur; had taken commercially reasonable steps to avoid a recurrence of the operational failure; and the operational failure occurred despite the diligent efforts of the employer. 
  • Relief is unavailable with respect to the exercise of any stock option or stock appreciation right that otherwise would result in a failure to comply with Section 409A (e.g., an exercise of a "discount" stock option).

Correction of Violation in the Same Taxable Year in Which the Violation Occurred. Notice 2007-100 provides generous relief for correcting operational violations in the same year they occur. In particular:

  • If a failure to defer an amount or an incorrect distribution is corrected in the same taxable year in which the failure occurred, the Section 409A violation generally is "cured" and the employee will not be subject to tax under Section 409A for the year in which the error occurs. In addition, if the plan is operated properly thereafter, only ordinary income tax will apply in the years distributions are made from the plan.
  • In order for the relief to apply, the employee must repay the employer the incorrect amount by December 31 of the year in which the violation occurs. For example, if an employee elected to defer 60% of an annual bonus for 2008 and the bonus is $100,000 ($60,000 should thus be deferred), but the employer pays the employee $80,000 and defers only $20,000, the employee can avoid income inclusion and the Section 409A penalties for 2008 if the employee repays the employer the $40,000 "excess" by December 31, 2008. Alternatively, the employer generally may withhold the $40,000 from other amounts payable to the employee in that year. Deemed earnings must also be part of the correction in certain circumstances.
  • If the employee is an "insider" (i.e., an officer, a director or a 10% shareholder of the employer), the amount repaid to the employer must include an interest payment based on the short-term applicable federal interest rate.
  • Special rules apply to stock options/SARs that are unintentionally "in the money" when issued and therefore are subject to Section 409A solely for that reason. In that event, the exercise price can be increased to the fair market value of the underlying shares as of the grant date (not the date of correction) by end of the employer’s taxable year in which the options/SARs were granted. In that event, the options/SARs will be treated as excluded from Section 409A coverage if they otherwise are excluded under the Section 409A rules (e.g., they do not include an additional deferral feature). However, it is important to note that this relief does not apply to options/SARs that are exercised before the date of correction.
  • Section 409A requires that distributions to a "specified employee" (i.e., a "top 50" officer of a public company) that are made in connection with the employee’s termination of employment be delayed until six months following termination. If the six-month delay is not imposed, the employee may repay the funds in the year of distribution pursuant to the rules summarized above. The employer then needs to delay the payment until the later of (i) when the six-month delay would have ended (or, if later, the date payment was due under the plan) or (ii) the number of days from the date the employer made the erroneous distribution through the date the distribution is repaid by the employee. For example, if a plan provides that a specified employee is entitled to payment on the first day of the seventh month following termination of employment, the employee terminates on November 15, 2007 (so that payment is due on June 1, 2008) and an early payment is made on May 1, 2008, the correction program generally would be available. If the employee repays the improper distribution on July 1, 2008, the employee would then be entitled to receive the corrected distribution on the later of (i) June 1, 2008, or (ii) 61 days after repayment (because the incorrect payment was outstanding for 61 days before it was repaid). Thus, under these facts, payment would be required to be made on August 31, 2008.
  • The employer must file a statement with its annual tax return for the year in which the error occurred and was corrected, and must provide the statement to the employee. The sole exception is for corrections of "in the money" stock options/SARs as noted above; no statement is required in that event. The employee is not required to file a statement with his or her tax return.

Correction of Violations Involving Limited Amounts Occurring During Taxable Years Before 2010. Notice 2007-100 provides much more limited relief for correcting operational violations in years after they occur. In general, principles similar to those discussed above apply. However, the correction program is available only if the improper payments do not exceed the Code section 402(g) pre-tax elective deferral limit applicable for the year in which the operational failure occurs (this limit is $15,500 for 2008). In addition, the amount that is "corrected" by repayment to the employer is still subject to income tax and the Section 409A additional tax in the year of distribution, but is not again taxed when it is properly distributed (although any earnings thereon are subject to ordinary income tax). Finally, this portion of the correction program is limited to errors that occur in taxable years beginning before January 1, 2010.

On its face, it may appear that this portion of the correction program is not particularly helpful to employees, since income tax and the 20% additional tax apply to the repaid amount. However, that appearance is deceiving. In general, if there is a Section 409A operational failure with respect to an employee, the employee is immediately subject to income tax and the Section 409A penalties on all amounts deferred under the plan with respect to which the error occurred and all other plans of the same type. For example, if an "early" distribution of $10,000 is made to an employee with a $2 million balance in the plan, the entire $2 million balance generally would be subject to income tax and the Section 409A penalties. The benefit of the correction program is that only the amount subject to the administrative failure is subject to the adverse Section 409A treatment. Thus, in the preceding example, the $1,990,000 remaining balance would not be impacted.

In addition to the fairly limited scope of the program with respect to corrections in years after the operational failure occurred, the program imposes more stringent reporting requirements than for "same year" corrections. Both the employer and the employee are required to file statements with the IRS along with their tax returns for the taxable year in which the operational failure was discovered.

Conclusion. The IRS should be commended for establishing the program. It will allow taxpayers to correct many operational errors and avoid (or at least limit) the draconian Section 409A penalties that can be imposed on innocent employees. 

Gibson, Dunn & Crutcher LLP

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