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409A In Operation: Recent Guidance on
Correcting Errors, Wage Reporting & Withholding
and Calculating Includable Income
Presented by Nancy A. StrelauFebruary 10, 2009
410 Seventeenth St. Suite 2200Denver, CO 80202
Brownstein Hyatt Farber Schreck, LLP
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409A In Operation
• Correcting Operational Errors IRS Notice 2008-113
http://www.irs.gov/pub/irs-drop/n-08-113.pdf
• Wage Reporting and Withholding Requirements IRS Notice 2008-115
http://www.irs.gov/pub/irs-drop/n-08-115.pdf
• Calculating Amounts Includable in Income for 409A Noncompliance
Proposed Treasury Regulations
http://www.irs.gov/irb/2008-51_IRB/ar14.html
Obama directive to delay
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Correcting Operational Errors
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Correcting Operational Failures
• Notice 2008-113 (December 5, 2008)
• No Relief for Document Noncompliance Operational Failures ONLY
Document compliance deadline was December 31, 2008
• Only Limited Relief for “Insiders” Who is an “insider”?
Directors Officers More than 10% beneficial owners (Section 16 of the Securities
Exchange Act)
Applies whether public or privately held
Applies to all entity forms, not just corporations
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Eligibility for Correction Program
• Operational failure must be inadvertent and unintentional
Failure to follow 409A(a) in practice
Failure to follow 409A-compliant plan terms
Failure cannot be related to listed transaction under Treas. Reg. section 1.6011-4(b)(2)
• Tax return of service provider (employee) must not be under IRS examination
Year in which operational failure occurred
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• Employer must have taken commercially reasonable steps to avoid future recurrence of the failure
For tax years after 12/31/09, if a similar failure occurred previously, employer must demonstrate that
Employer had established reasonable procedures to prevent recurrence of the failure and
Failure occurred despite the employer’s diligent efforts
• All requirements for the specific correction method must be met
• All notice and reporting requirements for the specific correction method must be met
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• If error involves an erroneous payment, payment must not coincide with employer’s substantial financial downturn or other issues indicating a significant risk that the payment would not be paid when due
• The operational failure must be fully corrected
• There can be no “make-up” payments from employer to employee
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General Categories of Operational Failures
• Payment of NQDC before the taxable year in which the amount was due to be paid under the terms of the plan
• Payment of NQDC more than 30 days before the date in the taxable year in which the amount was due to be paid under the terms of the plan
• Deferral of compensation less than or in excess of the amount that should have been deferred under the plan
• Payment of NQDC to a “specified employee” within 6 months of employment termination
• A stock right considered to provide for a deferral of compensation because exercise price is less than FMV on the date of the grant
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Correction Made in Same Year as Failure
• Failure to defer amount or incorrect payment of an amount otherwise payable in a later year
• Early Payment Failures Employee repays the employer before year end of error
Employee may have to pay interest to employer
Examples: Payments resulting from failures to process deferral elections Payments made 30 days or more before payment date
• Late Payment Failures Employer must repay the employee
Employer may have to adjust for earnings or losses
Examples: Excess or improper deferral
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• Non-Insider Payment Relief If service provider would incur an immediate and heavy
financial need if repayment made in the same year as error
Then repayment period may be extended for up to 24 months following the due date of employee’s tax return for the year in which the failure occurred
• Relief obtained No inclusion of income on vesting
No 20% penalty tax
No premium interest rate
No additional reporting and withholding
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Correction Made After Year of Failure
• Available to non-insiders only
• May only correct in the year immediately following the year in which failure occurred
• Failure to defer or incorrect payment
• Early Payment Failures Employee must repay the employer - 24 month rule may apply Employee may have to pay interest to employer
• Late Payment Failures Employer must repay the employee Employer may have to adjust for earnings or losses
• Relief Obtained No 20% penalty tax No premium interest rate No additional reporting and withholding
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Correction of Failures Involving Limited Amounts
• Failure must involve amounts less than annual elective deferral limit under IRC section 402(g)(1)(B)
$16,500 for 2009
• Limited relief to correct failures to defer small amount or erroneous early payment of small amount
• 409A income inclusion applies but limited to amount erroneously paid or made available
• Employee required to pay 20% tax Not required to pay the premium interest tax
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Correcting Discounted Stock Options
• Background Nonstatutory stock options and SARS granted at no less than
100% FMV on date of grant are exempt from 409A
NQSOs and SARS granted at less than 100% FMV are subject to 409A
Standard stock option can’t comply with 409A
• Correction - Employers can reset exercise price of stock option and SAR to 100% FMV on original date of grant
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• Correction must be made Before the stock right is exercised
For insiders – By December 31st of the year in which the stock right was granted
For non-insiders – By December 31st of the year following the year in which the stock right was granted
• Documentation must indicate the adjusted exercise price is to be at least 100% of FMV
• Relief applicable only to unexercised portion of the stock right
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• Employer’s Federal tax return for tax year of correction Must be timely filed
Must include statement - “Section 409A Relief under Section V of Notice 2008-113”
Name and TIN of affected employee Identifying information about the plan under which the grant was
made A description of the circumstances surrounding the
misstatement of the exercise price The steps taken for correction and the date(s) taken A statement that the mispricing is eligible for correction and that
all required actions have been taken
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• Notice to employee Contents similar to disclosure made with employer’s federal
income tax return
For corrections in same year, notice is discretionary
For corrections in following year, notice is required Employee must be informed that he has to attach this notice to
his personal tax return
Notice must be provided by Form W-2 distribution deadline for year in which correction made
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Correcting Payments to Specified Employees
• Background – NQDC payments upon termination of employment to a “specified employee” of publicly traded company cannot be made for six months
• Eligibility Documentation providing for the payment must incorporate a
6 month delay provision
• Specified Employee = key employee under IRC 416(i) Limited to 50 officers with compensation in excess of IRC
401(a)(17) limit ($160,000 for 2009)
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• Correction In Same Year as Mispayment By end of employee’s tax year, employee must repay the
gross value (including amount withheld for taxes) The repaid amount is not returned to the employee until
If repayment before the original correct payment date (the “6-month date”), new payment date is the 6-month date plus the number of days passed from the mispayment date through repayment date
If repayment after the 6-month date, new payment date is delayed for a number of days equal to the number of days from the mispayment date to the 6-month date
Adjustment for timing of withholding under IRC 6143 No adjustment for earning from mispayment date to
repayment date
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• Correction in Year After Year of Mispayment Not available to specified employees who are insiders
By December 31 of year following year of mispayment, employee must pay gross value of the amount that should have been paid on the 6-month date
Repaid amount is not returned to employee until the number of days after the repayment date as the number of day that passed from the mispayment date through the 6-month date
Mispayment is reported as income on Form W-2 for year of mispayment
Reduction permitted if payment crosses years
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• Employer’s Federal tax return for tax year of mispayment / year in which mispayment discovered
Must be timely filed
Must include a statement titled “Section 409A Relief under Section IV of Notice 2008-113”
Name and TIN of affected employee Identifying information about the plan under which the
mispayment was made A description of the circumstances surrounding the mispayment The steps taken for correction and the date(s) taken A statement that the mispayment is eligible for correction and
that all required actions have been taken
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• Notice to employee Contents similar to disclosure made with employer’s federal
income tax return
Employee must be informed that he has to attach this notice to his personal tax return
Notice must be provided by Form W-2 distribution deadline for year in which correction made
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What To Look Forward To
• Treasury Department and IRS considering a correction program for document failures
Seeking comments – due by March 6
• Possible extension of correction program for certain operational failures to allow service providers to repay an incorrect payment over an extended period
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Wage Reporting and Withholding Requirements
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Summary
• Notice 2008-115 (December 10, 2008)
• Extends guidance previously issued in Notice 2006-100 and Notice 2007-89
Continues to apply until further guidance issued
• Delays (again) the requirement for employers to report 409A compliant deferrals
• Explains how withholding and reporting requirements apply to includible amounts
• Explains how to calculate amounts includable in income for noncompliant NQDC plans
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Employer Reporting and Wage Withholding
• 2008 Annual Deferrals For deferrals in 2008, suspends requirement to report on
Form W-2 (box 12, code Y) or Form 1099-MISc (box 15a)
• Reporting & Withholding on Amounts Includible in Gross Income
If NQDC plan fails to comply with 409A and amounts are includable in gross income for 2008, employer must treat such amount as “wages”
Employer must withhold federal income taxes at the applicable rate
Treated as “supplemental wages” to determine tax rate
Reported on Form 941 and Form W-2 (box 1 and 12, code Z)
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• Calculation of amounts includible under 409A(a) for 2008
Amount includible in gross income for 2008 equals The portion of total amount deferred that is vested at 12/31/08
and not included in prior year income and Amounts paid in 2008
Exclude Grandfathered amounts (earned and vested before 1/1/05) Amounts reported on 2005, 2006 or 2007 Form W-2 or Form
1099-MISC
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• Determining Amounts Includible in Income Under 409A Total amount deferred Account balance plan = total account balance as of 12/31/08 Nonaccount balance plan = if amount is “reasonably
ascertainable,” present value of future payments to which employee has a right on 12/31/08; uses regulations under IRC 3121(v)(2)
Stock right = amount employee would include in income if right exercised on 12/31/08
FMV of stock less exercise price
Other = Reasonable good faith application of a reasonable good faith method
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• Wage Payment Date for 2008 Includable Amounts Wages = amounts actually or constructively received during
2008
Wages = amounts not actually or constructively received but are includible under 409A(a) treated as paid on 12/31/08
Employer can withhold required taxes before 2/1/09
Employer can pay the required withholding and treat the amount as additional wages to employee
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Amounts Includible In Income under 409A(b)
• Amounts includible in gross income under 409A(b) Must be determined under a reasonable good faith
application of a reasonable, good faith method
Must be treated as wages for withholding and reporting
• Amounts subject to transition relief under Notice 2006-33 not includible income if NQDC plan became compliant with 409A(b) by 12/31/07
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Protection from Future Additional Reporting and Withholding for 2008
• Employer that complies with Notice 2008-115 regarding computation of amounts includible in gross income will have no liability for additional income tax withholding or penalties resulting from future guidance
• Employer also will not be required to furnish corrected reporting as a result of future guidance
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Service Provider Requirements
• Employee must report as income and pay taxes due on amounts includible in gross income by operation of 409A
• Calculate amounts per Notice 2008-115
• If fail to report and pay taxes on 2008 includible amounts may be subject to additional taxes and penalties
Interest on underpayments or taxes resulting from a failure
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Impact on Transition Relief
• Notice 2007-86 extended the deadline for amending NQDC plans for 409A compliance to 12/31/08
• If comply with Notice 2007-86, and have operational compliance, amounts deferred under NQDC should not be includible income for 2008 or any subsequent year
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Calculating Amounts Includable in Income for 409A
Noncompliance
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• Proposed Regulations address: Calculation of amounts that must be included in taxable
income if NQDC doesn’t comply with 409A in form or operation
Calculation of the additional 20% penalty tax applicable to such income
Calculation of the premium interest tax on amounts that should have been included in taxable income in prior years (underpayments)
• Degree of reliance on proposed regulations to be determined in future guidance
• White House memo dated January 20, 2009
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• General rule – If NQDC plan fails to comply with 409A in form or operation, service provider (employee) will recognize income equal to the compensation deferred to the extent vested
• Consequences Includible income subject to income tax at regular rate plus
20%
Includible income may be subject to an additional premium interest tax
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Amounts Includible in Income
• In event of a 409A failure, the amount includible in income means the “total amount deferred” under the NQDC plan for the taxable year less the portion that is unvested or previously included in income
“Previously included in income” = Amounts actually income on an original or amended tax return or as a result of an IRS examination or court decision
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Total Amount Deferred for a Taxable Year
• Total Amount Deferred for a Taxable Year Equals: Present value of the future payments to which the service
provider has a legally binding right on the last day of the taxable year PLUS
The payments of deferred that are made during the year Proposed regulations specify in detail how present value is
calculated – varies for different types of future payments – and the assumptions that can be used
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• Account balance plan Total of the account balances
• Nonaccount balance plan Present value of future payments
Disregard potential additional service credits
Disregard compensation increases after year end
• Unexercised stock option or SAR The spread value on the last day of the taxable year
The cash and FMV of the stock to be received on exercise, less the exercise price
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Application of Additional 20% Tax
• This tax is subject to the rules governing the assessment, collection and payment of income taxes
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Premium Interest Tax
• This is an additional tax to account for underpayment of taxes in prior years
• Amount of premium interest tax The interest at the applicable underpayment rate plus 1% that
would have been owed on the tax underpayment that would have occurred if the deferred amount had been included in income for the prior taxable years in which it was first deferred or became vested
• This tax is subject to the rules governing the assessment, collection and payment of income taxes
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• Proposed regulations contain detailed methodology for calculating the premium interest tax
• Allocates the amount includible in income under 409A(a) to the prior taxable years in which the amount or portion thereof was first deferred or became vested
• Then determines the hypothetical tax underpayment for each prior taxable year
Allocated amount is treated as additional cash compensation paid to the service provider during the prior taxable year
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• Hypothetical tax underpayment is calculated based on Deemed payment of additional cash compensation (above)
Service provider’s taxable income, credits, filing status and other tax information for the prior taxable year
Availability of deductions Use of carryovers
• Hypothetical tax underpayment calculation in subsequent years must consider changes in previous taxable year
As a result of the additional compensation income treated as paid in such previous year
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Allocation to Subsequent Payouts
• Any amount included in income under 409A is not required to be included under any other provisions of the Code at any later time
• Proposed regulation describe the process for determining when amounts paid from an NQDC plan are treated as previously included in income
Deemed basis in the deferred compensation payments is recovered first
The first payments are treated as amounts already included in income until the deemed basis is recovered
After basis is recovered, payments will be includible in income
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Deduction for Forfeited Amounts
• Proposed regulations provide for the treatment of deferred compensation that was included in income, but was never received due to permanent forfeiture
• Taxpayer can take a deduction for the taxable year in which the forfeiture occurs
As long as no amounts remain deferred under the plan
• Deduction equal to the forfeited amount previously included in income, less any portion allocated to subsequent payments under the deemed basis recovery procedure (described above)
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Correcting Future Compliance Failures
• Failure in one taxable year may not cause a continuing or permanent failure
Failure to comply with 409A(a) during a taxable year would not result in the taxation of amounts deferred under the plan for subsequent taxable years if the plan complies during those subsequent years
• The deferred compensation amount includible in income under 409A for any taxable year is determined on a year-by-year basis
Determined as of the last day of the year Excludes amounts subject to a substantial risk of forfeiture
(vesting)
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• Significance If NQDC plan is noncompliant at some point during a year and
If, as of the last day of the year, all of the employee’s deferred compensation is not vested
Then 409A penalties won’t apply for that year to compensation deferred by the employee under the NQDC plan
• Also If prior to the year in which deferred compensation becomes vested,
the NQDC plan is amended and operates in compliance with 409A
Then 409A penalties won’t apply in the vesting year or subsequent years
• Don’t rely on as a planning tool, though!! Treasury Department and IRS authority to prevent abuse of this rule
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CONCLUSION / RECOMMENDATONS
• IRS gearing up for enforcement?
• Correction program rewards early detection and correction
Less tax
Easier procedures
• Don’t be an ostrich Address discovered issues immediately
Implement measures to prevent occurrence / recurrence of failures
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CONCLUSION / RECOMMENDATONS
• Action steps: Conduct internal audit
Correct identified operational failures
Create an oversight committee
Develop written procedures
Train personnel
Counsel / notify participants
Timely report income and excise taxes
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Questions?
Nancy A. StrelauBrownstein Hyatt Farber Schreck, LLP
410 Seventeenth Street, Suite 2200Denver, CO 80202
(303) [email protected]
