Employers that maintain nonqualified deferred compensation plans should strongly consider adding a review of operations for Section 409A non-compliance to their end-of-the-year to-do lists. If operational failures are identified and corrected before the year has run out, it may be possible to avoid some or all of the adverse consequences that would otherwise result under 409A by taking advantage of the relief provided under IRS Notice 2008-113.

Even the best administered plan will have operational errors crop up from time to time. Despite an employer's efforts to develop robust administrative procedures, operational plan failures can arise in various ways.

• Faulty implementation of a deferral election. It just takes one errant key stroke to cause an elective deferral to be implemented incorrectly. An elective deferral of 20 percent of salary may be wrongly keyed in as 10 percent or 30 percent, resulting in an impermissible acceleration or deferral, respectively, under 409A.
• Wrong form of benefit payment. Here's an example of how a benefit can be paid in the wrong form: A plan may provide for payment to be made in annual installments if the amount exceeds a certain threshold. Otherwise, payment will be in a lump sum. Although the benefit amount fails to satisfy the required threshold for installments, payments commence in installments rather than lump-sum form, resulting in an impermissible deferral.
• Payroll errors. Payroll errors resulting in 409A operational failures can arise in myriad ways. The culprit often is incorrect coding, which can occur at any time but frequently when systems are updated or substantially modified. One scenario: A plan that provides for elective compensation deferrals defines "compensation" to include short-term disability pay. When the employer's payroll system is updated, however, short-term disability pay is not coded as compensation to which the participant's deferral election should be applied, and the participant's short-term disability pay is paid to the participant—an acceleration under 409A—instead of being deferred.

409A Failures Burdensome for Participants and Administrators

There is ample reason for employers to take special pains to avoid 409A operational plan failures. For the plan participant, a 409A failure has potentially brutal consequences. Among these are current inclusion of the deferred compensation in the participant's gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), 20 percent additional tax on those amounts, and premium interest (interest at the underpayment rate plus one percentage point) on any underpayment of tax on amounts that were includible in income due to the 409A failure.

Operational plan failures under 409A also create certain administrative headaches for the employer. Employers are obligated to report failures on the affected participant's Form W-2 and to withhold on those amounts (or, in the case of an independent contractor, report the amount on Form 1099).

Early Detection Rewarded

If an administrative review is conducted before year end and operational errors rooted out and corrected, it may be possible to avoid some of this parade of horribles. In Notice 2008-113 the Internal Revenue Service provides procedures for correcting what it casts as operational plan failures to provide the taxpayer certain relief from the full application of 409A.

The relief provided in the Notice is broadest for operational plan failures corrected in the same year, and becomes progressively less generous—ultimately disappearing altogether—for errors corrected in successive tax years. In so doing the Notice "rewards" early detection and correction of operational plan failures. This is particularly true in the case of "insiders"—defined in the Notice as a director or officer or 10 percent owner of the employer, determined in accordance with the rules under Section 16 of the Securities Exchange Act of 1934—for whom the relief for corrections made after the plan year in which they occurred is substantially less than for errors corrected in the same year.

Relief Not Designed as Backstop

A year-end 409A operational review serves another important purpose: to evidence the employer's vigilance in avoiding recurring operational errors that could jeopardize the continued availability of relief under Notice 2008-113. Lest employers come to rely on the relief in the Notice as a backstop for administrative laxity, the Notice requires an employer to take "commercially reasonable steps" to avoid a recurrence of the operational failure. Beginning after December 31, 2009, serial reliance on the Notice will not be permitted where the same or substantially similar failures previously occurred. An exception is provided, however, if the service provider or service recipient can demonstrate that the service recipient had established procedures reasonably designed to ensure that the operational failure would not recur and had taken commercially reasonable efforts to avoid the recurrence, and that despite the service provider's diligent efforts, the error nonetheless occurred. Therefore, the employer will want to undertake an operational review not only to correct errors before year end, but also to be able to demonstrate its efforts to prevent recurrences.

Allow Time to Make Corrections

Employers that wait until the last minute to review their plan operations for 409A failures may find themselves scrambling in late December. There is some effort involved in performing the steps required by Notice 2008-113 in order to obtain the desired relief for operational plan failure corrections. Employers will want to avoid, for example, trying to obtain crucial information from short-staffed third-party recordkeepers during the last week of the year. No employer will want its failure to budget time to be the reason that a 409A operational plan error went uncorrected in 2009.

Relief Does Not Cover Documentary Failures

If in your review of plan operations you stumble across a 409A documentary plan failure, no relief will be available for that under Notice 2008-113, whose relief extends solely to operational failures. However, the Internal Revenue Service has suggested that a corrections program for 409A documentary plan failures is in the works—and may be announced before the end of the year.

Administrative Errors Not Always 409A Plan Failures

Finally, bear in mind that not all administrative glitches constitute a violation of 409A. For example, if a deferred compensation payment that is scheduled for March 1 of a given year is delayed to a later date in the same year, that delay is not a violation of 409A, as provided in Treasury Regulation section 1.409A-3(d). Further, while Notice 2008-113 provides a correction method for what the IRS casts as operational failures, in some cases an employer may wish to consider whether the failure really reflects a failure of the plan to comply with 409A. If the participant's rights under the plan remain the same regardless of the mistake, the employer may want to think about whether it is appropriate to view that mistake as a payroll error or tax reporting error, but not a 409A operational failure.