Compensation Arrangements: Code Section 409A - Penalties and Corrections

This is the ninth in a series of articles that we hope will provide you with a better understanding of the rules applicable to certain compensation arrangements under Section 409A of the Internal Revenue Code (“409A’”).[1] In this installment, we will discuss the penalties for failure to comply with 409A and recent IRS guidance regarding corrections.

What happens if a “plan” is not in compliance with 409A?

The primary penalty for non-compliance is on the individual “service provider” (employee or independent contractor), not the employer. If an arrangement is not excluded from 409A coverage or is not properly drafted and operated in accordance with the requirements of 409A, then the compensation will be taxable as soon as it is vested or, as stated in 409A, when it is no longer subject to a “substantial risk of forfeiture.” In addition, the employee or “service provider” will incur a 20% penalty tax, plus interest back to the later of the original date of the deferral or the vesting date, at the applicable IRC underpayment rate, plus 1%. Similar additional taxes may be imposed by states. The employer could be assessed penalties for reporting and withholding violations.

What will happen if operational non-compliance with 409A is unintentional?

The IRS has issued guidance on an administrative corrections program for 409A operational failures. It is still considering whether to issue corrections guidance as to documentation failures.

As with all 409A matters, the corrections procedures for operation errors are highly detailed. The applicability of corrections requires that procedures be adopted that include all commercially reasonable steps to avoid recurrence. Correction is not applicable if the service provider is under federal tax examination for the tax year in which the error occurred.

Corrections include the following, but there are others:

• An erroneous early payment of an amount due in a later year can be repaid within the same year as an erroneous payment. Insiders (officers, directors and direct or indirect owners of at least 10%) must pay interest on larger payment amounts.
• An erroneous early payment of an amount due in the same year can be repaid within the same year as the erroneous payment.
• An excess deferred amount can be corrected in the same tax year. Accounts of insiders (officers, directors and direct or indirect owners of at least 10%) must be adjusted for interest; accounts of others may be adjusted for interest. Interest may be paid on corrected deferrals to adjust for the delayed payment.
• A failure to establish the correct fair market value exercise price for deferred compensation involving stock rights can be corrected within the same year of grant and before exercise by resetting the exercise price to the accurate fair market value.
• An early payment or deficient deferral for non-insiders can be corrected in the first year following the year of the error. The erroneous payment or deficient deferral amount is taxable in the year received but the repayment is deductible in the following the year when early payment is repaid or deficient deferral is corrected.

All these and other corrections have additional detailed conditions that should be reviewed with the assistance of your counsel.

Our last (10th) installment will provide you with an action plan for compliance.

[1]Our first installment provided a brief introduction to 409A, and our second installment discussed the intent of 409A. Our third installment discussed what constitutes a “plan” under 409A, and discussed the terms and conditions must be contained in a “plan” in order for it to comply with 409A. Our fourth installment discussed the types of arrangements that are not subject to 409A. In our fifth installment we discussed some of the special rules that apply in order for certain equity-based compensation arrangements to be exempt from 409A. Our sixth installment discussed severance pay arrangements that do not satisfy the separation pay exemption from 409A. Our seventh installment discussed reimbursements and welfare benefit arrangements under 409A. Our eighth installment discussed some of the 409A rules that are applicable to the traditional deferral arrangement – where the “service provider” elects to defer the receipt of compensation from the “service recipient”.