Revenue Procedure 98-19: Correcting Deferral Failures

Correcting operational failures in a nonqualified deferred compensation (NQDC) plan is governed by rules from the Internal Revenue Service (IRS). Administrative errors, such as failing to properly execute a deferral election, can violate Internal Revenue Code Section 409A. These violations can trigger adverse tax consequences, including immediate income inclusion of all deferred amounts, a 20% additional federal tax, and a premium interest tax.

To mitigate these penalties, the IRS established a self-correction program under Notice 2008-113. This guidance allows employers and employees to rectify certain mistakes and restore the intended tax treatment without formal IRS approval, provided all conditions are met.

Eligibility for Relief

To use the relief for an operational failure, both the employer and the employee must meet specific criteria. The program applies only to unintentional administrative errors, such as when a deferral election is not implemented correctly, causing too little or too much compensation to be deferred. Relief is available for failures affecting both new and long-term participants.

The employer must take commercially reasonable steps to identify and correct all similar failures within a limited time frame. This relief is not available if the IRS has already discovered the failure before the correction process begins.

Required Corrective Actions

After identifying a failure, the employer must take specific corrective actions based on the type of error. If an amount was improperly paid to an employee, the employee may be required to repay it to the company. If an amount was improperly deferred, the employer must distribute the excess deferral, plus earnings, to the employee.

The earnings calculation must adjust the account to reflect the balance it would have had if the error had not occurred. Deadlines for these actions are strict, with many corrections required by the end of the employee’s taxable year in which the error is discovered.

Any corrective distribution for an excess deferral is treated as taxable wages for that year. The employer must report this amount on the employee’s Form W-2 and withhold applicable employment taxes.

Procedural Filing Requirements

After taking corrective action, the employer must document the correction by providing informational statements to the IRS and the affected employee. The employer must attach a statement to its timely-filed federal income tax return for the year the failure was discovered. This statement notifies the IRS that the employer has used the self-correction program.

The document must include the names and taxpayer identification numbers of the employer and employee, a description of the failure, and the corrective steps taken. It must also include a representation from the employer declaring that all requirements of the applicable IRS notice have been satisfied. The employer must provide a similar statement to the employee, informing them of the failure and the correction for their records.