Internal Revenue Code Section 409A ("409A") imposes complicated rules on deferred compensation plans. Plans that do not follow their terms and the 409A rules can create painful taxable events for participants, including immediate taxation of past deferred compensation and additional taxes on those amounts.
To maintain compliance and correct inadvertent operational failures under the IRS 409A correction program described in IRS Notice 2008-113, plan administrators may want to consider an ongoing review of their administration, which might include:
Deferral Elections
- In January, ensure new salary deferral elections for the current year are implemented timely and correctly.
- In March and April, companies with annual incentive payments based on the calendar year should ensure that annual bonus deferral elections are properly applied and new bonus deferral elections are implemented.
- For example, a plan that has participants make year-end bonus deferral elections (e.g., deferral elections are made by December 31, 2023 for 2024 salary and the 2024 bonus (i.e., the bonus paid in March 2025)) will want to make sure that the bonus deferral election made in 2023 is applied to the 2025 bonus payment, and once the 2025 bonus payment is made, the 2024 bonus deferral election (i.e., the election made by December 31, 2024 for the bonus earned in 2025 and paid in 2026) is input into the recordkeeping system.
- For example, a plan that has participants make year-end bonus deferral elections (e.g., deferral elections are made by December 31, 2023 for 2024 salary and the 2024 bonus (i.e., the bonus paid in March 2025)) will want to make sure that the bonus deferral election made in 2023 is applied to the 2025 bonus payment, and once the 2025 bonus payment is made, the 2024 bonus deferral election (i.e., the election made by December 31, 2024 for the bonus earned in 2025 and paid in 2026) is input into the recordkeeping system.
- Throughout the year, monitor the process of allowing newly eligible participants to start deferrals mid-year. Generally, elections must be made within 30 days of the individual becoming initially eligible to participate in a deferred compensation plan, and the deferral elections can only apply to compensation earned after the deferral election becomes irrevocable.
- Practice tip – This rule can prevent participants from electing to defer sign-on bonuses unless deferral elections are made prior to showing up at work and before any service period begins.
- Practice tip – This rule can prevent participants from electing to defer sign-on bonuses unless deferral elections are made prior to showing up at work and before any service period begins.
- If a plan allows performance-based compensation deferral elections, make sure that the participants are eligible to make the deferral election.
- The compensation must meet the requirements for performance-based compensation (i.e., it is contingent on performance criteria based on a period of at least 12 months, and the criteria are established in writing no later than 90 days after the beginning of the performance period).
- The participant has been continuously employed by the employer since the later of: (1) the beginning of the performance period or (2) the date of the establishment of the performance criteria through the date of the deferral election. Also, the deferral election must be made no later than six months before the end of the performance period and before the amount of performance-based compensation is substantially certain to be paid.
- Practice tip – This rule prevents most newly hired individuals from using the performance-based deferral election during their first year of employment, and the newly eligible participant deferral rule may need to be used to allow deferrals that comply with 409A.
- The compensation must meet the requirements for performance-based compensation (i.e., it is contingent on performance criteria based on a period of at least 12 months, and the criteria are established in writing no later than 90 days after the beginning of the performance period).
Distributions
- In January, identify any payments that are required to be made in the current year based on a distribution event in a prior year (e.g., fixed-date payment, a delayed payment on a separation from service, or continuing installment payments). A schedule of payments prepared in advance can help make sure payments are made timely.
- In January, if the plan allows for trailing deferrals (e.g., continuing bonus payments) or employer credits after termination, make sure such amounts are considered for distribution purposes as described in the plan document.
- Throughout the year, check the employment status of participants to make sure all distribution events have been identified and payments are made as elected or required by the plan.
Corrections
- IRS Notice 2008-113 has very specific corrections for each type of operational failure. The corrections allowed under Notice 2008-113 are not the same as corrections the IRS allows for qualified retirement plans. The 409A correction rules are complicated and may require that interest on overpayments to the participant be paid to the company, may not allow earnings to be paid to the participant on underpayments, may impose additional taxes on the participant, and could require the participant to file an amended tax return for a prior year.
- Corrections of 409A failures are allowed up to the end of the second year after the year of the failure. Failures cannot be corrected after that date, but instead there are 409A errors that trigger additional taxes for the impacted participant and reporting obligations on the employer.
- The allowed corrections under Notice 2008-113 are generally more participant-friendly the sooner the corrections are made.
- Practice tip – Some 409A failures may have multiple correction approaches available. When deciding which correction is best, employers may want to factor in if the correction method requires repayment of interest by the participant, imposes additional taxes, or requires the participant to file an amended tax return for a prior year.
- Practice tip – Some 409A failures may have multiple correction approaches available. When deciding which correction is best, employers may want to factor in if the correction method requires repayment of interest by the participant, imposes additional taxes, or requires the participant to file an amended tax return for a prior year.
- Corrections of 409A failures are allowed up to the end of the second year after the year of the failure. Failures cannot be corrected after that date, but instead there are 409A errors that trigger additional taxes for the impacted participant and reporting obligations on the employer.
- Start the correction process early!
- If a distribution is missed or delayed, special 409A rules allow the late distribution to be treated as paid timely if the missed payment is made by the later of the end of the taxable year of the participant that includes the correct payment date (which is generally the calendar year) that includes the correct payment date) or the 15th day of the third calendar month following the correct payment date.
- If deferrals are not made timely, they must generally be collected from participants to avoid a 409A error. Starting the correction process early allows time to communicate to the impacted participant about the failure and correction steps. Participants generally do not react well to letters in December saying they have $5,000 of missed deferrals that need to be paid to the company by the end of the month.
- 409A corrections need to be reported to the IRS on the employer's tax return for the year of correction. For 409A corrections that are not completed in the same year as the failure occurred, each impacted participant must also file a correction statement with their federal tax return. The employer must issue the correction statement to the participant no later than January 31 of the year after the year of correction.
- Practice tip – Coordinate with the employer’s tax department about the timing of the employer’s federal tax return to make sure that the required company 409A correction is attached.
- If a distribution is missed or delayed, special 409A rules allow the late distribution to be treated as paid timely if the missed payment is made by the later of the end of the taxable year of the participant that includes the correct payment date (which is generally the calendar year) that includes the correct payment date) or the 15th day of the third calendar month following the correct payment date.
Special FICA Considerations
- For deferred compensation plans that are considered account balance plans for FICA purposes, employer credits are generally subject to FICA taxes when they are no longer subject to a substantial risk of forfeiture (i.e., FICA taxes apply when the amounts are vested).
- Many employers use special rules to simplify the FICA taxation process to a single date for all plan participants, including the administrative convenience rule (i.e., include the vested amount, plus the value of reasonable interest, for FICA purposes as of a later date in the calendar year) and the lag rule (include an amount, plus the value of reasonable interest, within 3 months of the date it would otherwise be included for FICA purposes).
- Practice tip – Early retirement features can trigger early vesting of amounts in deferred compensation plans, which also triggers when FICA taxation is required.
- Practice tip – Plans that take advantage of the administrative convenience rule and/or lag rule should also track distributions to terminated participants to make sure that FICA has been collected on all vested amounts before the final distribution is made.
- Practice tip – Early retirement features can trigger early vesting of amounts in deferred compensation plans, which also triggers when FICA taxation is required.
- Many employers use special rules to simplify the FICA taxation process to a single date for all plan participants, including the administrative convenience rule (i.e., include the vested amount, plus the value of reasonable interest, for FICA purposes as of a later date in the calendar year) and the lag rule (include an amount, plus the value of reasonable interest, within 3 months of the date it would otherwise be included for FICA purposes).
If you have any questions or need help with your 409A questions and corrections, contact your MMM Employee Benefits & Executive Compensation attorney.
