Correcting Section 409A Operational Failures

An operational failure under Section 409A of the Internal Revenue Code is an error in the administration of a nonqualified deferred compensation plan. These are not flaws in the plan’s written documents but mistakes in its day-to-day operation, such as paying an amount at the wrong time. The Internal Revenue Service (IRS) provides a formal correction program under Notice 2008-113 that allows employers and employees to fix certain operational mistakes and avoid the significant tax penalties that would otherwise apply.

Eligibility for Correction Relief

To use the IRS correction program, both the employer and employee must meet several requirements. The operational failure must not be part of an abusive tax avoidance transaction, and the relief is for inadvertent mistakes. Eligibility is restricted if either the employer or the employee is under an IRS examination concerning nonqualified deferred compensation for the tax year in which the failure occurred. The program is also unavailable for failures related to certain stock rights or for errors that are egregious or involve self-correction by insiders in certain situations. The employer must also take commercially reasonable steps to prevent a recurrence of the failure.

Correctable Operational Failures

The IRS guidance outlines specific categories of operational failures that can be corrected. Catching and correcting a failure within the same taxable year it occurs allows for a full correction without penalties.

Failure to Defer or Incorrect Deferral Amount

One common error involves the failure to defer an amount an employee elected to defer, or deferring an incorrect amount. This can happen if an employer mistakenly pays an amount as current wages instead of setting it aside. To correct this, the employee must repay the erroneously paid amount to the employer before the end of the taxable year in which the error occurred.

Incorrect Payment in the Same Year

Another correctable failure is making a payment from the plan during the taxable year that was not scheduled to be paid. If this error is discovered in the same year, the correction involves the employee repaying the full amount of the premature distribution back to the employer. The repayment must be made before the end of that same taxable year to avoid tax penalties under Section 409A.

Incorrect Payment in a Subsequent Year

The correction program also provides relief for certain failures discovered the year after they occur. If an amount was incorrectly paid in one year and fixed in the next, correction is possible with more stringent requirements. This relief is generally not available for insiders, such as directors and officers. The employee must repay the amount plus an interest charge to compensate for the time value of the premature payment.

Limited Amount Failures

For smaller errors that are not corrected within the same or subsequent year, a limited correction may be available. This applies if the amount involved in the failure does not exceed the statutory limit on elective deferrals for qualified retirement plans for that year. This correction can significantly reduce the tax impact by limiting the income inclusion and the 20% additional tax to only the amount of the erroneous payment, rather than the employee’s entire plan balance.

Information and Statements for Correction

Properly documenting the correction is a requirement of the relief program. The employer must attach a specific statement to its timely filed federal income tax return for the year the failure occurred. If the correction is not completed within the same taxable year, the affected employee must also attach a similar statement to their return. For failures corrected within the same year, only the employer is required to file this disclosure.

The statement must be labeled “Correction of a Section 409A Operational Failure under § IX of Notice 2008-113” and contain the following information:

• The employee’s name, address, and taxpayer identification number.
• The name of the nonqualified deferred compensation plan.
• A description of the failure, including the date it occurred and the amount involved.
• A representation that the failure is eligible for correction and that all necessary steps have been taken to fix the error.
• A description of the corrective actions and the date the correction was completed.

The Correction and Filing Process

The employer must attach the completed statement to its income tax return for the taxable year in which the operational failure took place. If the employee is also required to file a statement, they must attach it to their return for the same year, and these returns must be filed by their due dates, including any extensions. Upon proper filing by the required parties, the correction is deemed complete.

Failure by the employer to attach the statement will invalidate the correction. If the employee is also required to file, their failure to do so can also invalidate the relief, potentially exposing both parties to Section 409A penalties.