With the end of 2010 in sight, employers should immediately re-examine all compensatory plans and agreements subject to Section 409A of the Internal Revenue Code (Section 409A) to ensure that any eligible violations are identified and fully corrected by December 31, 2010. Uncorrected violations of Section 409A expose plan participants to early inclusion in income of the full amount of the affected deferred compensation, a 20-percent additional federal income tax on the amount included in income, and interest. Employers are subject to penalties for failure to properly report and withhold taxes. 

The Internal Revenue Service (IRS) has implemented two correction programs to assist employers who discover errors affecting compensatory plans and arrangements subject to Section 409A. First, in 2008, the IRS issued a correction program in Notice 2008-113 for certain operational failures, which may be corrected in the year of the failure or in the year following the failure. Second, the IRS issued Notice 2010-6 on January 4, 2010, providing a program to correct unintentional plan document failures. There are strong incentives, as explained below, in Notice 2010-6 to correct by December 31, 2010.

On November 30, 2010, the IRS issued Notice 2010-80 providing additional guidance on the two correction programs. Notice 2010-80 expanded the types of nonqualified deferred compensation plans that are covered under the document correction program and provided an additional method of correction and transition relief for certain plan document failures relating to payments at separation from service, such as an employee’s release of claims within 90 days following separation from service. Additionally, Notice 2010-80 modified the reporting requirements in Notice 2008-113 and Notice 2010-6.

The document correction program provided by Notice 2010-6 requires the employer to comply with the specific correction procedures for the identified document failure. In some instances, the procedures under Notice 2010-6 require the plan participant to include a percentage of the affected deferred compensation in income and pay the 20-percent tax on the amount included. However, plans corrected in accordance with Notice 2010-6 by December 31, 2010, may be treated as having been corrected on January 1, 2009, such that the penalties under Section 409A may be avoided (although an amount may be required to be included in income under Section 409A due to the correction of the related operational failure).

Plan document failures that may be corrected pursuant to the document correction program set forth in Notice 2010-6 include:

• Impermissible definitions of an otherwise permissible payment event (e.g., separation from service, change in control, or disability);
• Impermissible discretion with respect to payment of benefits following a permissible payment event (e.g., a payment conditioned upon the employee executing a general release when delivery of the release affects the timing of the payment);
• Impermissible payment events and payment schedules;
• Impermissible discretion to accelerate payment events; and
• Failure to include the six-month delay for a payment upon separation from service of a “specified employee.”

Notice 2010-80 provides transition relief that extends beyond December 31, 2010, for one specific plan document failure. It is common for severance provisions that constitute deferred compensation to include language that provides payment will be made “within” a specified number of days following termination of employment (e.g., 90 days), provided the employee executes a release. The IRS has indicated that agreements containing this language provide impermissible discretion to the employee executing the release. The IRS did not clarify this position until after employers began amending plans and arrangements to comply with Section 409A. Therefore, plans and arrangements that have been amended to comply with Section 409A should be reviewed again. The IRS is not requiring correction of this language before year end. If a plan or agreement contains this language, action may be necessary pursuant to Notice 2010-80 or Notice 2008-113 during 2011 or 2012, depending on when the payment is made.

Employers should review all compensatory plans and arrangements that are subject to Section 409A as soon as possible to allow time to correct any document failures prior to year end to take advantage of the favorable correction provided by Notice 2010-6 and to correct any operational failures that are required to be corrected prior to year end by Notice 2008-113. 

If you need assistance in determining if you have any arrangements subject to Section 409A or in identifying or correcting violations of Section 409A, please call your Vinson & Elkins Employee Benefits and Executive Compensation practice contact or any of the Employee Benefits and Executive Compensation practitioners listed below. Visit our website to learn more about V&E's Employee Benefits and Executive Compensation practice.