Deferred Compensation Document and Operational Errors
By: Roger Prince, JD, APA
2010 is the last year to fix many errors to your nonqualified deferred compensation arrangements without substantial penalty. After 2010, failure to comply with the Internal Revenue Code’s Section 409A can be enormously expensive.
Not only are the penalties for failure under Section 409A draconian, but the statute and regulations are so complex that documentary and operational errors are all but certain to occur.
Some of the penalties and consequences are:
The good news is that the IRS recognizes that errors are inevitable and has created a self-correction process for document and operational errors. The bad news is that avoiding adverse tax consequences requires very early error detection and correction. In other words, if you snooze, you lose.
Document Errors
The IRS recently provided information to employers on self-correcting certain document errors in their nonqualified deferred compensation plans. The Service has decided to take a carrot and stick approach to the timing of such corrections. The earlier a problem is detected and corrected, the better chance there is of avoiding income inclusion, penalty tax and interest. This is particularly true for 2010.
Given the newness of the document correction program, the IRS has decided to allow employers to correct current or prior year nonqualified deferred compensation plan document errors during 2010 without incurring adverse tax consequences. This is a tremendous opportunity for employers to correct document errors that might otherwise result in significant income tax and penalties.
Because you don’t know if there’s a document error without performing a document review, we recommend that employers with certain types of arrangements make sure that an expert has reviewed their written documentation to make sure it complies with Section 409A. The review should happen as soon as possible in 2010 so there will be time to correct any document errors--and any resultant operational errors--before the end of 2010.
Here are the arrangements which should be examined:
*Nonqualified deferred compensation plans
(e.g., Deferral Arrangements, SERPs, SAR arrangements, Phantom stock plans)
*Post year-end bonus arrangements
*Incentive pay arrangements
*Severance agreements
*Employment Agreements with deferred pay provisions
After 2010, the document correction program will still allow correction, but significant income tax and penalties may be incurred in many situations. Such tax and penalties will be less than would otherwise be experienced if the document correction program did not exist, but they can still hurt. Thus, we strongly advise employers to have their arrangements reviewed now.
Operational Errors
The IRS has also instituted a Section 409A operational error correction program. Like its document correction counterpart, this program rewards those who discover and correct errors early. The operational error correction program distinguishes between errors involving employee “insiders” and all other employees. For this purpose, the definition of “insider” is quite broad; defined as any director or officer of the employer or a person who, directly or indirectly, owns more than 10% of the employer equity (whether or not the employer is public, and whether or not the employer is a corporation). In a large number of cases, the employees for whom deferred compensation plans are designed are going to be insiders!
The time frame for operation error correction can be tricky. Usually the only way to correct an operational error for an insider without any early taxation and penalty is to discover and fully correct the error in the same calendar year that the error occurred.
The only realistic way for an employer to meet such a deadline is to have proper internal controls and a functional review process in place. Leaving the review until year-end leaves insufficient time to make the necessary corrections.
Non-insider employees are granted more leeway with respect to the timing of operational corrections, but they are still better off to correct in the same year the error occurred.
Need Help Sorting Through It?
We can answer questions you may have about the Section 409A correction procedures or conduct an independent plan review for you. We have extensive experience reviewing qualified retirement plans for operational errors and stand ready to apply the same rigorous procedures to your nonqualified deferred compensation plans. Remember, the IRS rewards employers who act early – this is especially true for 2010.
The information presented above is only of a general nature and should not be relied upon with respect to any particular fact pattern or situation. If you need additional advice or have specific questions, please contact either Roger Prince at rprince@bdmp.com or Bill Enck at benck@bdmp.com.