How to Avoid Tax Penalties on Deferred Comp

Put a review of administrative practices relating to deferred compensation on your year-end to-do list.
Andrew LiazosNovember 21, 2011

It’s that time when everyone is thinking about what needs to get done before the end of the year. One item to add to the list is reviewing the administrative operation of the company’s nonqualified deferred-compensation plans during the past year. No matter how good your plan administration is, errors will occur from time to time. If corrective action is not taken by year-end, these errors may expose executives to significant federal-tax liability and employers to tax-reporting obligations.

The Internal Revenue Code provides for harsh penalties on executives when nonqualified deferred-compensation plans are not operated in compliance with fairly strict election and benefit payment rules under Section 409A. Unless relief is available, violating Section 409A triggers immediate income tax on vested deferred-compensation benefits — a 20% addition to tax and premium interest tax — even though no amount has been received by the executive.

Fortunately, there is an ability to correct many types of administrative errors that can occur during the course of the year. IRS Notice 2008-113 sets forth procedures for correcting operational errors that avoid triggering the full penalties under Section 409A taxation. If an administrative review is conducted before year-end, corrective actions often can be completed for many errors that occurred earlier in the year without triggering any taxes.

So, what types of errors are covered? A common error is failure to pay an amount that was due earlier in the year because of a special event (such as employment termination) or processing the wrong form of payment (such as installments when the required payment form is a lump sum). Even though full payment was due earlier this year, there are no penalties or requirements to make any special corrective filings if the payment is made by December 31. Indeed, this particular type of violation can be fixed without the benefit of Notice 2008-113.

Another common type of error is faulty payroll processing of election forms. Failures can range from typing in the wrong deferral percentages, to coding compensation to be deferred incorrectly, to applying deferral percentages to the wrong individuals. These failures result in either not enough or too much compensation being deferred. Failures to defer can often be remedied by repayments before year-end along with a simple notice to the IRS.

The relief for correcting these types of errors after the year in which they occurred becomes much less generous over time (requiring partial payment of the Section 409A tax in some cases) and disappears completely after two years. That is particularly true in the case of so-called insiders, who are generally defined as directors and officers under the Section 16 insider-trading rules. Insiders are afforded less relief than noninsiders for violations that are corrected in a later year.

Another benefit of performing a year-end review of payment and election processing is to preserve the ability to use Notice 2008-113. The ability to correct a violation otherwise covered by the notice is generally not available for serial offenders. Employers must take commercially reasonable steps to avoid recurring operational failures as a precondition for being able to make corrections under IRS guidance.

So, it’s important that payroll and human-resources functions review these matters soon to avoid having to scurry around during the last week of the year, particularly if a correction involves a repayment. Undertaking this review requires some effort and may necessitate the involvement of a third-party record keeper. Nevertheless, having to address administrators’ errors in later years will be much more painful.

Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.