Though Sec. 409A was signed into law in 2004, the IRS continues to issue guidance to ease the burden of complying with the new nonqualified deferred compensation (NQDC) rules. Over the past year, the IRS has released several noteworthy pieces of guidance.

Sec. 409A Transitional Guidance

Beginning on January 1, 2009, taxpayers are required to comply with the Sec. 409A final regulations, which were released in April 2007. Until then, taxpayers must operate an NQDC plan in compliance with the plan’s terms, to the extent consistent with Sec. 409A and applicable IRS guidance (including Notice 2005-1 and other notices). Where a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely on either Notice 2005-1 or the final regulations, but generally may not rely on the proposed regulations after December 31, 2007.

In October 2007, the IRS released Notice 2007-864 to extend transition relief until January 1, 2009, in the following areas:

• The deadline for a plan to allow the selection of the time and form of payment;
• The ability for taxpayers to “reform” options by making the exercise price equal to the fair market value of the underlying share at exercise (thus exempting them from the Sec. 409A rules);
• The deadline for Sec. 409A compliance for NQDC plans linked to qualified plans; and
• The transition rule that requires income inclusion in the year following the year in which a violation occurs. Thus, if no corrective action is taken by the end of 2008, violations will first be reported in 2009.

Some taxpayers are using this transition to accelerate income into early 2009 in hopes of avoiding increased taxes in the future. Whether this is a good idea or not depends on future tax rates and the current schedule of payments. In no event can a payment be moved into 2008.

Correction Program for Sec. 409A Operational Failures

Acknowledging the requests of practitioners nationwide, in December 2007 the IRS issued Notice 2007-100, providing narrow relief for limited Sec. 409A operational failures. Notice 2007-100 addresses the correction of operational errors made during the same tax year and correction of certain de minimis operational failures in the year following the year of the failure. Exercise of a discounted stock right results in a failure under Sec. 409A and is specifically excluded from correction.

The relief provided by Notice 2007-100 is in addition to adjustments or corrections that may be available under current transition relief, which is generally scheduled to expire on December 31, 2008. In addition, Notice 2007-100 includes an extensive request for comments on a potential correction program. Moreover, while Notice 2007-100 may be helpful to some taxpayers under limited circumstances during the transition period, its greater significance is as a first step toward a post-transition relief correction program.

Basic requirements: A service recipient can only rely on Notice 2007-100 if it meets certain basic eligibility requirements. The failure must be an unintentional failure to (1) comply with plan provisions that conform to Sec. 409A or (2) follow Sec. 409A in practice due to inadvertent errors in plan operation. The failure cannot be egregious or related to participation in a “listed transaction” under Regs. Sec. 1.6011-4(b)(2).

The service recipient must take commercially reasonable steps to avoid recurrence of the failure. If the same or a substantially similar failure has happened before, relief is available after December 31, 2008, only if the service recipient had subsequent to the initial failure established practices and procedures reasonably designed to ensure that the failure would not recur and had taken commercially reasonable steps to avoid recurrence. In addition, the service provider’s annual income tax return cannot be under examination for the year of failure. Finally, certain corrections for erroneous payments are not available during tax years in which the service recipient experiences a substantial financial downturn or displays other indicia of a significant risk that the service recipient would not be able to pay the amount deferred when due.

Taxpayers who rely on Notice 2007-100 have the burden of showing that they satisfy its requirements and the application of the notice is subject to IRS examination. Toward these ends, Notice 2007-100 requires certain reporting and disclosure requirements.

Correcting failures within the service provider’s tax year: If the service provider meets the eligibility requirements, it may be able to correct certain unintentional operational failures during the service provider’s tax year in which such failures occur. The allowable correction method
depends on the type of failure and Notice 2007-100 identifies the following types of correctable failures:

• Early payments and failed deferrals: In general, early payments (amounts deferred in a prior year that should be paid in a future year but are mistakenly paid or made available during the current year) and failed deferrals (amounts otherwise payable in the current year that should have been deferred to a future year but are mistakenly paid or made available during the current year) can be repaid to the must also wait additional time — equal to the number of days it held the mistaken payment — after the original six-month period expires before it can receive payment. Notice 2007-100 seems to require actual repayment rather than withholding from other payments.
• Excess deferrals: Notice 2007-100 also provides a specific correction related to a mistake in retaining amounts that were not subject to a deferral election if the amounts are distributed by the end of the service provider’s current tax year. This rule does not apply to amounts deferred in the service provider’s prior tax years. If the service provider is an insider, its account balance or benefit must be adjusted for any positive earnings attributable to the mistaken deferral. For non-insiders, an adjustment for earnings or losses is optional. In any case, any adjustment generally must be made by the end of the service provider’s tax year, but if that is impracticable and the service provider and service recipient each have a legally binding right with respect to the adjustment as of that date, it may be made later, retroactive to that date. The service recipient may pay reasonable interest to the service provider for the use of its money, as long as it is paid or made available by the end of the service provider’s tax year.

Methods for limiting taxes after the service provider’s tax year: If an unintentional operational failure is not corrected by the end of the service provider’s tax year in which it occurs, Notice 2007-100 does not allow the service provider to avoid tax under Sec. 409A(a) by correcting the failure; however, if certain additional requirements are met, the amount of tax the service provider owes may be limited to ordinary income taxes and the 20 percent additional tax under Sec. 409A(a)(1)(B)(i)(II) on the amount of the failure. Other amounts deferred under the plan or under similar plans are not currently taxed and the interest penalty tax under Sec. 409A(a)(1)(B)(i)(I) does not apply.

Conclusion

Notice 2007-100 is an important first step that taxpayers can use in certain specific situations. It is less important in 2008, the last transition year in which good-faith compliance is sufficient, but will be increasingly important as the regulations take effect and taxpayers unwittingly continue to violate these rules. The IRS is already examining these issues and this will become even more prevalent in future years.

Deborah Walker is a tax partner at Deloitte Tax LLP in Washington, DC. Mark Neilio is a tax manager at Deloitte Tax LLP in Washington, DC. Michael Haberman is a tax manager at Deloitte Tax LLP in Parsippany, NJ. Walker, Neilio and Haberman are contributing writers of The Tax Adviser. Their views as expressed in this article do not necessarily reflect the views of the AICPA, The Tax Adviser or the AICPA CPA Insider™.