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IRS Provides Relief for Unintentional Operational Violations of Section 409A

Buff Miller and Tom Reicher, of Cooley Godward Kronish LLP


On December 3, 2007, the IRS issued Notice 2007-100, which provides relief for certain unintentional operational failures to comply with Section 409A. As discussed in our prior Cooley Alerts, Section 409A of the Internal Revenue Code covers a wide range of nonqualified deferred compensation plans and arrangements and imposes a number of strict requirements on such plans and arrangements for participants to avoid premature taxation, an additional 20% federal income tax, and an interest-charge tax.

The Notice provides relief for two categories of unintentional operational failures under Section 409A: (1) certain failures that are corrected within the same taxable year in which they occur; and (2) certain failures that occur prior to 2010, are not corrected in the same taxable year and involve only limited dollar amounts. The types of failures included in each category are similar (except as described below). However, if corrected properly, failures in the first category may avoid income inclusion and additional taxes under Section 409A completely, while the relief provided for failures in the second category minimizes (but does not entirely eliminate) the amount of income inclusion and additional taxes.

The first category under the Notice covers the following four types of unintentional operational failures: (1) premature payments of amounts that otherwise should have been deferred; (2) failures to delay payments to specified employees for six months; (3) deferrals of amounts that should not have been deferred; and (4) stock options and stock appreciation rights that are granted with an exercise price below the fair market value of the underlying stock on the grant date.

In order to qualify for the complete relief available pursuant to the Notice, the failure must be corrected within the same taxable year in which it occurs. The Notice sets forth the specific methods for correcting each type of failure, which, for certain types of failures, includes additional requirements for individuals who are directors, officers or 10% stockholders of the employer.

The second category under the Notice covers the same types of failures as in the first category, except for failures regarding the exercise price of stock options and stock appreciation rights. If a failure is unable to qualify for the complete relief offered for failures in the first category (e.g., because the failure is not corrected in the same taxable year in which it occurs), there still may be limited relief available under the Notice, provided that the failure occurs prior to 2010 and involves only small dollar amounts ($15,500 for 2007 and 2008).

Certain requirements must be satisfied in order to qualify for relief under either category. First, the operational failure must be unintentional, non-egregious and unrelated to participation in an abusive tax-avoidance transaction.

In addition, relief is not available for certain failures that occur during a year in which the employer experiences a substantial financial downturn or other issues that indicate a significant risk that the employer will not be able to pay the deferred amounts when due. Relief also is conditioned upon the timely filing and provision of certain information by the employer to the IRS and the affected individual. Finally, the employer must take commercially reasonable steps to avoid a recurrence of the operational failure.

The Notice also provides an outline of a potential corrections program that is being considered by the IRS. The potential program may make the transition relief for failures under the second category available on a permanent basis and cover other failures that do not qualify for correction under the Notice.

It is important to consider that the Notice applies only to operational failures and does not provide any relief for documentary compliance failures. As discussed in our prior Alert, the documentary compliance deadline for plans and arrangements subject to Section 409A has been extended to December 31, 2008. Operational compliance with Section 409A, however, has been required since January 1, 2005. Accordingly, for purposes of operational compliance, companies should consider whether there have been any operational failures since January 1, 2005 that may be corrected under the Notice, with particular attention to 2007 operational failures that could be corrected before January 1, 2008.

Circular 230 Disclosure

The following disclosure is provided in accordance with the Internal Revenue Service's Circular 230 (21 CFR Part 10). This Alert is not intended to constitute tax advice to any specific taxpayer or for any specific situation. Any tax advice contained in this Alert is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person.

If you have any questions about this Alert, please contact one of the attorneys listed below.


Buff Miller, bmiller@cooley.com, joined Cooley Godward Kronish in 1999 as a partner in the Firm's Business department. He is resident in the Firm's Palo Alto office. Mr. Miller has extensive experience in the areas of federal and California income tax law and federal estate and gift tax law. His practice spans issues of interest to business clients from choice of entity questions at the initiation of business, research and development activities as the business grows and merger and acquisition activities as the business matures. His practice also involves planning for significant net worth individuals including wealth transfer planning, charitable contribution planning and equity compensation planning.

Tom Reicher, treicher@cooley.com, is a partner in the Cooley Godward Kronish Business department and the head of the Compensation & Benefits practice group. He is resident in the Firm's San Francisco office. Mr. Reicher specializes in the areas of employee benefit plans, equity compensation plans and executive compensation. Since 1980 he has advised employers with respect to the design and implementation of all types of retirement and deferred compensation plans, including 401(k) plans, ESOPs, defined benefit plans and cash balance pension plans. In the area of medical and other welfare benefit plans, he has assisted employers with the establishment and administration of self-funded health plans, flexible benefit plans, dependent care plans and a wide range of severance benefit plans.

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