Executives are at risk of early income inclusion, a 20% penalty tax, and interest charges if their compensation arrangements violate the evolving guidance under Internal Revenue Code Section 409A, which means that it is important to periodically review these arrangements. If you have not already done so, you should review your executive compensation arrangements in light of the guidance under Notice 2010-80, in which the IRS expanded its explanation of provisions that it deems to violate Section 409A.
The good news is that through this Notice, the IRS has expanded the ability of employers to correct errors in different types of arrangements. This Notice provides employers with an opportunity to identify errors in the written documents or the administration of these arrangements, and take action to reduce or eliminate the penalties that would be applied if these errors were discovered on audit.
As background, many of executive compensation arrangements, including non-qualified deferred compensation plans (“NQDC Plans”), employment agreements, severance agreements, change in control agreements, and equity compensation plans, are required to follow strict deferral election and payment timing rules under Section 409A. If these rules are not satisfied, executives may face early income inclusion, a 20% penalty tax on the compensation subject to these arrangements, and additional interest charges. In recent years, the IRS issued correction programs in which certain errors could be corrected with the penalties on executives being reduced or even eliminated. These programs, however, were somewhat narrow with scope causing concern that some arrangements may not be able to be corrected. The Notice expands the ability to take advantage of these programs in the manner described below.
1. Linked Plans. The Notice clarifies that an NQDC plan that is linked to a qualified plan is eligible to take advantage of the corrections program, provided that the linkage does not affect the time and form of payments under either plan. In other words, if the NQDC plan is linked to a qualified plan solely for purposes of calculating the amount of the NQDC benefit, the NQDC plan is eligible to use the corrections program to correct any Section 409A errors. This relief is helpful because many types of linked plans, such as 401(k) wrap plans and supplemental executive retirement plans, will be able to take advantage of the corrections programs.
2. Stock Rights. Stock options and stock appreciation rights (collectively, “Stock Rights”) previously were not able to be corrected in any program. The Notice now allows Stock Rights that were intended to comply with Section 409A to be able to use the corrections program. Such Stock Rights must require recipient to exercise the right only within a fixed year or on a permissible payment event under Section 409A. Stock Rights that were intended to be exempt from Section 409A (i.e., allowed the recipient to exercise the right at anytime) are not eligible for this relief. Because most stock rights are designed to be exempt from 409A, the scope of this relief may not be as large as some practitioners might have hoped, but it is still beneficial to have some ability to fix Stock Rights.
3. Employment Agreements. Under previous guidance, the IRS stated that making the timing of severance payments conditioned upon the execution of a release of claims could be a Section 409A violation unless the timing of the payment was structured within a narrow set of guidelines. The Notice makes these guidelines somewhat more flexible. Specifically, an agreement may structure the timing of payment under one of the following methods:
- If the arrangement provides for payment within a designated period after a permitted triggering event under Section 409A, the arrangement may provide that the payment may be made on the last day of the designated period. If the period begins in one taxable year and ends in the next taxable year, the payment must be made in the later taxable year.
- If the arrangement does not provide for payment within a specified period after a permitted triggering event under Section 409A, the arrangement can provide for the payment to be made either:
- On the 60th day or 90th day after the permissible payment event; or
- During a specified period not longer than 90 days after a permissible payment event. If the period begins in one taxable year and ends in the next taxable year, the payment must be made in the later taxable year.
Further, any plan or agreement that was effective on or before December 31, 2010, generally may be amended to comply with one of the above mentioned provisions by December 31, 2012. This relief may be the most useful contained in the Notice. Under prior guidance, there was some concern over the difficulty of making severance pay conditioned on the signing of a release compliant with Section 409A. The Notice addresses these concerns by providing specified procedures for drafting such agreements.
4. Information Reporting Relief. Although the original correction programs provided relief from some of the penalties applicable to a Section 409A failure, they required both the employer and the employee to disclose certain information on their respective tax returns for the year that the corrections were made. The Notice provides that the information reporting requirements do not apply to employees for certain types of documentary corrections made on or before December 31, 2011, and for corrections made to employment agreements in the manner described in Part III before December 31, 2012. The employer, however, still must file information on its tax return. In addition, the information reporting requirements no longer apply to employees with respect to plan operation errors that are corrected in the year they are made.
5. Recommended Action. Although the relief is targeted only to certain types of arrangements, employers should review any NQDC plan, equity compensation plan, or other arrangement that is subject to Section 409A to identify and correct errors under the Notice. In particular, employers should review any employment agreement, severance agreement, or change in control agreement to determine whether any payments under these agreements are conditioned upon an employee signing a release of claims, non-competition agreement, or similar arrangement.