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December 31 is the deadline to fix certain mistakes—and avoid Section 409A penalties
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The approach of the end of the year means this is the time to drill down on any operational errors in nonqualified deferred compensation plans. Internal Revenue Service (IRS)
Notice 2008-113 provides relief from Internal Revenue Code Section 409A penalties for operational errors that occurred earlier this year and in 2013. It also addresses 2012 operational errors and confirms that December 31, 2014, is the deadline for obtaining relief for 2012 errors.
The Notice, however, does not provide relief for errors left uncorrected more than two years after they occurred. The following road map highlights the available correction options for certain early and missed nonqualified plan payments that occurred during 2012, 2013 and 2014.(This article does not address erroneous payments to specified employees subject to the six-month waiting period or failures related to stock rights.)
Early payment—Amount distributed in 2014 that should have been deferred in 2014.
Erroneous payments made earlier this year should be repaid to the plan by December 31. Repayments may take the form of a lump sum or installments (with interest), except that installments generally are available only if the service provider who received the erroneous payment is not a company insider (insiders generally are directors, officers and 10 percent equity owners).
Installments must be pursuant to a binding agreement over a term that does not exceed 24 months after the due date of the service provider’s tax return for the year that includes the erroneous payment, among other requirements. Lump sum repayments from insiders are subject to additional interest requirements.
There is no requirement to include repaid amounts repaid in income or report them as income on Form W-2 (or, if applicable, Form 1099-MISC), but appropriate employment tax adjustments should be made if taxes were withheld on the early payment. Notwithstanding this, any earned compensation reduced to repay the early payment still is income. Taxes withheld on the early payment, however, may be applied to reduce taxes owed on the compensation used to repay the amount. The account balance may be adjusted for earnings (or losses) retroactive to the date the amount should have been deferred. Most importantly, no Section 409A penalties apply.
Missed payment—Amount should have been paid earlier in 2014.
If the plan failed to issue an amount that was payable earlier this year, the plan should make the payment by December 31. There is no requirement to pay interest on the missed payment; however, the remaining account balance must reflect the distribution.
An earnings adjustment
may be made if the service provider is not an insider, but
must be made if the service provider is an insider (retroactive to the date the plan should have made the payment). Reporting follows the general rules for nonqualified plan payments (i.e., Form W-2, Boxes 1 and 11; Form 1099-MISC). Again, assuming timely payment, no Section 409A penalties apply.
Early payment—Amount distributed last year that should have been deferred last year.
If the service provider is not a company insider, IRS guidance provides relief if the provider repays (with interest) any early distributions paid in 2013 by December 31. The guidance permits lump sum payments as well as installment payments, subject to certain conditions. If the service provider is an insider, the rules below concerning early payments in 2012 apply.
Early 2013 payments are income and must be reported on Form W-2 or Form 1099-MISC for 2013 (i.e., the year the plan erroneously paid the amount). Note that this requires a revised 2013 form, but a partial deduction may be available due to the additional income and repayment. The remaining account balance may be adjusted for earnings or losses retroactive to the date the plan should have deferred the amount. If the plan originally deferred the amount but erroneously paid it in 2013, Notice 2008-113 permits retroactive adjustment to the erroneous payment date.
Keep in mind that the Notice provides special relief for small (“limited”) amounts that do not exceed the IRS limit for elective deferrals under qualified plans (for 2012, $17,000; for 2013 and 2014, $17,500). For this small payment rule, there is no requirement to repay the erroneous distribution although it must be included in income for the year of payment (i.e., requiring an amended 2013 Form W-2 with Code Z in Box 12). Section 409A’s additional 20 percent tax will apply to the amount, but not the premium interest tax.
Missed payment—Amount should have been paid last year.
If the plan failed to distribute amounts payable in 2013 to a service provider who is not an insider, Notice 2008-113 provides relief from Section 409A’s additional 20 percent tax and premium interest tax if the plan distributes the missed payment by December 31. Interest cannot be paid on the late payment. The plan
must adjust the remaining account balance for earnings, but may adjust for losses also. For insiders, the additional 20 percent tax applies, but earnings may be paid. The general reporting rules for nonqualified plan payments apply.
Early payment—Amount distributed in 2012 that should have been deferred in 2012.
December 31 is the deadline for repaying erroneous 2012 distributions. Installment payments are not available, and special interest rules apply to repayments by insiders. Service providers must report early 2012 payments as income for 2012 (i.e., amended 2012 Form W-2, Box 12, Code Z) and pay the additional 20 percent tax. The premium interest tax does not apply, and deductions are not available for the repayments. Any remaining account balance may be adjusted for earnings (or losses) retroactive to the date the amount should have been deferred. If the plan originally deferred the amount but paid it in error in 2012, the account may be adjusted retroactive to the erroneous payment date.
Missed payment—Amount should have been paid in 2012.
Likewise, the plan should distribute missed 2012 payments by December 31. After this date, there is no relief from Section 409A penalties. Missed 2012 payments distributed by December 31 must be reported as income for 2012 (i.e., amended 2012 Form W-2, Box 12, Code Z). They are subject to the additional 20 percent tax, but not the premium interest tax. For any remaining account balance, the plan may pay or forfeit earnings attributable to the late payment.
The Notice’s limited payment rule also provides relief, assuming the missed payment amount falls below the applicable dollar limit and the plan pays it by December 31. The late payment is income for 2014 and the additional 20 percent tax applies, but not the premium interest tax. The plan may pay or forfeit allocable earnings, and may disregard or subtract losses.
Again, errors preceding 2012 are not eligible for relief under Notice 2008-113. For pre-2012 errors related to amounts still in the plan, plan counsel can advise whether a constructive receipt approach is appropriate. However, errors eligible for relief under the Notice should take the highest priority.
If there are errors, start the discussions now with the plan’s record keeper. Record-keeping firms generally are amenable to resolving errors in a timely fashion to reduce compounding year-end distribution issues. Most firms reconcile their systems during the fourth quarter, especially late November through December, for qualified plan required minimum distributions and distributions owed to terminated participants.
Although nonqualified plans have separate record-keeping platforms, corrective action for nonqualified plan errors should be on the radar.
To qualify for relief, corrections must be made by December 31. From a practical standpoint, this means corrective payment requests must be negotiated and resolved sometime on or before December 24, 2014, to allow sufficient time for holiday-related market closings and associated trade and settlement. Keep in mind that
the check must be cut by December 31. The required information statement and return (including any amended Form W-2 or Form 1099-MISC) can be issued in January.
Christina M. Crockett is an employee benefits attorney at Ogletree Deakins in Washington, D.C. She assists employers and other plan sponsors with compliance concerns related to developing, implementing and administering all types of employer-sponsored benefit programs.
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