409A Failures: Correcting Outside of The IRS

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409A Failures Correcting Outside of The IRSs
Formal Correction Programs
DC Bar Luncheon Program February 25, 2010

• Rosina B. Barker
• Ivins, Phillips Barker
• 1700 Pennsylvania Ave., N.W.
• Washington, DC 20006
• [phone]
• rbarker_at_ipbtax.com

IRS Circular 230 Disclosure IRS regulations
require us to advise you that any tax advice
contained herein was not intended or written to
be used and cannot be used for the purpose of
avoiding federal tax penalties.
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Background Code Section 409A

• Applies to deferred compensation (except
  qualified plans, certain welfare benefits, and
  arrangements specified by regulations, e.g.,
  complying options, SARs)
• Payouts
• Only on dates, schedules or permitted triggers
  specified by plan
• No Accelerations
• Six-month rule for payouts to specified employees
• Deferral elections and second elections limited
  as to timing, effect
• Compliance required in form and operation
• Significant tax penalties for failure

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IRS Administrative Correction Programs

• Notice 2010-6 Document Failures
• Penalty-free correction of failures corrected
  in 2010
• Significant reporting requirements
• After 2010, many corrections available only
  subject to one-year rule
• Some errors not correctible under any
  circumstances
• Errors in option contracts
• Errors in plans linked to qualified plans
• Haircuts (employee discretion to accelerate)
• Notice 2008-113 Operational Failures
• Correction of
• Mistaken accelerations (including
  six-month/30-day rule failures)
• Mistaken deferrals
• Options with strike price mistakenly set below
  FMV on date of grant
• Penalty-free in some circumstances
• Significant reporting requirements

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Nonvested Compensation

• Prop. Treas. Reg. Sec. 1.409A-4
• Available only for nonvested compensation
• Anti-abuse rule
• Open question Corrections made in vesting year
  before vesting date
• Year end snapshot rule Prop. Treas. Reg. Sec.
  1.409A-4(a)(2)(i)
• Better reading Correction is effective
• Operational failures
• Taint rule - failure causes tax for vested
  compensation in same aggregated plan (same
  bucket) in same year
• Document failures
• No taint rule - plan aggregation (bucket) rule
  does not apply
• Option and SAR failures
• No taint rule - plan aggregation (bucket) rule
  does not apply

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Document Errors Definitional Questions

• What is the Plan?
• Aggregation (bucket) rule of Treas. Reg.
   1.409A-1(c)(2)(i) does not apply
• Other questions remain
• All promises in same instrument?
• Each identifiable promise?
• Where is the plan located?
• Treas. Reg.  1.409A-1(c)(3)(i) The terms of
  the plan may be set forth in one or more
  documents

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Document Errors Correcting the Contract 1

• Background 409A codifies constructive receipt
  doctrine
• Legislative history Inappropriate levels of
  control or access
• Statute at any time rule of Treas. Reg. Sec.
  1.451-2(a)
• Subheading Rules relating to constructive
  receipt
• Structure elections, second elections
  permitted no haircuts six-month rule
• Mutual assent obligee not in constructive
  receipt of unfunded, unsecured promise to pay
  money in the future until mutually-agreed payment
  date
• Doctrine is what makes deferral elections
  effective
• E.g., Robinson Basila Metcalfe Amend
  Millsaps Palmer Schniers, Veit II
• 409A shows Congresss intent to retain
  effectiveness of deferrals
• Section 132 Revenue Act of 1978 versus Prop.
  Treas. Reg. Sec. 1.61-16(a)(1) dominion and
  control
• 409A under NESTEG proposed to repeal Section
  132
• 409A as enacted NESTEG proposal dropped,
  constructive receipt retained

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Document Errors Correcting the Contract 2

• Constructive receipt recap - enforceable
  agreement to defer compensation to later date
  mutually agreed on by obligor and obligee
• 409A Legally binding right to deferred
  compensation, with written instrument requirement
• This means a contract with an integration clause
  inserted by statute
• Normal contract construction rules apply
• Confined to documents
• Intent governs - Extrinsic evidence permitted for
  certain interpretive purposes
• This is so even for an integration
• This is so even when written agreement required
  by statute
• Mathews v. Sears Pension Plan (ERISA Section
  402(a)(1))
• Cf. Buchine v. Cmmr. 20 F.3d 173 (5th Cir. 1994)
  (I.R.C. Sec. 6013(e)).

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Document Errors Correcting the Contract 3

• Ambiguous document Intrinsic ambiguity
• Basic rule of contract interpretation When
  document ambiguous, all evidence admitted,
  including extrinsic evidence, to determine intent
• Whats the source of ambiguity?
• Strong example Notwithstanding any other
  provision of this agreement, no election shall be
  given effect and no payment shall be made, to the
  extent such election or payment would give rise
  to taxation under section 409A.
• Treas. Reg. Sec. 1.409A-1(c)(1) cannot nullify
  noncompliant plan terms or supply required plan
  terms
• Compare Contract law notwithstanding clause
  overrides contradictory clear terms (Cisneros v.
  Alpine Ridge Group, 508 U.S. 10 (1993) Morse
  Diesel Inc v Trinity Industries Inc., 67 F.3d 435
  (2d Cir. 1995))
• Notice 2010-6 Sec. IV.B could disambiguate
  inherently ambiguous terms

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Document Errors Correcting the Contract 4

• Intrinsically ambiguous documents, cont.
• IRSs 409A view consistent with 2056 view
  savings clause cannot override clear terms, or
  introduce ambiguity, but can be used to interpret
  inherently ambiguous terms
• Revenue 75-440, 1975-2 C.B. 372 TAMs 200234017,
  199932001, 9104003
• Compare Contract law infers ambiguity from
  document as a whole
• Estate tax marital deduction cases follow
  contract law principles
• Estate of Cline, T.C. Memo 1982-90 Estate of
  Alexander (dictum) Estate of Mittleman, 522 F.2d
  132 (D.C. Cir. 1975) (revg U.S.T.C. No. 2340-70)
• Conclusion Use strong savings clause for
  ambiguity in clear but inconsistent noncompliant
  terms
• Make sure savings clause strong enough to
  introduce ambiguity Cautionary cases Aramony
  v. United Way of America, 254 F.3d 403 (2d Cir.
  2001) (Aramony II) Estate of Sawyer, T.C. Memo
  1988-132

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Document Errors Correcting the Contract 5

• Non-ambiguous document Scriveners Error
• One term used two ways
• Mutual mistake cured by reformation versus
• Extrinsic ambiguity shown by extrinsic evidence,
  resolved by interpretation
• Non-top hat ERISA plans compare 7th Circuit (
  Mathews v. Sears Pension Plan) with 4th Circuit
  (Blackshear v. Reliance Std. Life Ins. Co.)
• Extension of SOL - compare Woods v. Cmmr. (Tax
  Court) with TAM 8435014
• Reformation/mutual mistake is not what you want
  to argue
• Discretionary remedy by court using its equitable
  powers
• IRS does not have to follow
• Extrinsic ambiguity is just another exercise in
  doc interpretation

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Document Errors Correcting the Contract 6

• Extrinsic ambiguity for 409A doc interpretation
• Whats the plan? Even if not part of the plan,
  docs usable to show intent
• Participant communications, shareholder
  communications, Comp committee meeting minutes
  other objective evidence of both parties shared
  intent, written or oral
• Introduce omitted terms
• ERISA non-top hat Rosetto v. Pabst Brewing
  Company, Inc. 217 F.3d 539 (7th Cir. 2000) Bock
  v Computer Assocs, 257 F.3d 700 (7th Cir. 2001)
  The Boeing Company v March, 2009 U.S. Dist. Lexis
  82533 Mathews v. Sears Pension Plan
• Tax cases Sharewell, T.C. Memo 1999-413
• Override inconsistent terms
• Tax cases State Pipe Nipple Corp., TC Memo
  1983-339 Estate of Sowder v US, 407 F.Supp. 2d
  (E.D. Wash. 2005) affd 9th Cir.

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Document Errors Correcting the Contract 7

• Additional interpretive questions
• Thumb on the scale Deferred compensation
  presumptively good, bad or neutral?
• IRS view as stated in public speeches
• Contrary view supported by legislative history
  Congressional affirmation of elective deferrals
• Penalty provisions narrowly applied (Cmmr. v.
  Acker, 4 AFTR 2d 5778 (S. Ct. 1959) Frelbro Corp.
  v Cmmr., 315 F.2d 784 (2d Cir. 1963) )
• Effect of regulation disregarding savings clauses
  scope?

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Document Errors Rescission 1

• If, in a taxable year, transaction cancelled and
  parties returned to status quo ante, income
  arising from transaction in year of rescission
  cancelled
• Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940)
  Revenue Ruling 80-58 (note -states doctrine too
  narrowly)
• Annual income accounting tax years before
  rescission not affected
• Does status quo ante rule bar doctrines
  application to compensation?
• Apparently not -
• Status quo ante rule cant be satisfied in
  pay-for-services context, nonetheless, rescission
  doctrine still available - Penn PLRs 9104039
  200752035
• When replacement value granted after
  cancellation, rescission may still be available -
  PLR 200752035 (compensation), PLR 200752025
  (rescind preferred stock issue to parent, issue
  common, consistent with original intent taxwise )

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Document Errors Rescission 2

• Uses and limits of standard rescission theory
• Example 1 Document error in first vesting year
  (where plan defined without bucket rule)
• 409A guidance No sure fix (New plan rule of
  Notice 2010, Sec. X)
• Rescission doctrine noncompliant compensation
  cancelled, compliant replacement compensation
  granted. Does status quo ante rule allow
  replacement pay all the way back to beginning of
  year?
• Example 2 Document Error detected and fixed in
  year after vesting year?
• 409A No
• Rescission doctrine fixed for year of
  rescission
• Example 3 Option failure discovered after grant
  year, but in first vesting year
• 409A guidance no fix
• Rescission doctrine rescind option, grant new
  option with strike price equal to FMV of
  underlying stock on grant date. Lose value of
  spread between original grant date and new grant
  date.
• Or does rescission doctrine apply differently for
  compensation?

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Document/Operational Errors Other
Consent-Based Approaches

• General Principle Obligee is not in actual or
  constructive receipt of income he doesnt want,
  hasnt agreed to get, and doesnt know about
• (1) Mistaken payment returned in the same year
• Payment unwound for tax purposes if made contrary
  to mutual intent of the parties and returned in
  same taxable year when payment restores parties
  to their original intent (Couch, 1 BTA 103
  (1924), acq. IV-1 C.B. 1 (1925) Russel, 35 BTA
  602 (1937), acq. 1937-1 C.B., plus numerous
  progeny
• Two foundational principles
• Income depends on mutual assent of parties
• Annual income accounting
• No status quo ante rule
• Available even if payment not disclaimed, but
  redeferred or recharacterized Van Fleet Davis v.
  US Revenue Rulings 79-311, 78-198

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Document/Operational Errors Other
Consent-Based Approaches

• Mistaken payment returned in same year, cont.
• Example Payment due 2010, mistakenly paid 2009,
  returned in 2009
• Notice 2008-113 Failure, corrected under program
• Couch/Russel No failure because no payment,
  when payment made contrary to shared intent of
  parties, and returned to restore to their
  original intent
• To demonstrate parties real intent, consider a
  strong savings clause (No payment shall be
  made etc.)
• Applicable to document errors where failure
  would cause income?

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Document/Operational Errors Other
Consent-Based Approaches

• (2) Mistaken payment - the unwilling payee
• Illinois Power Co. v. Commissioner, 792 F.2d 683
  (7th Cir. 1986) (taxpayer is allowed to exclude
  from his income money received under an
  unequivocal contractual, statutory, or regulatory
  duty to repay it, so that he really is just the
  custodian of the money) Bates Motor Transport
  Lines, Inc.
• Potential correction of unwanted payment or
  income made in previous taxable year can
  overcome high hurdle of claim of right doctrine
• But note that payee generally aware of fact of
  payment (but not necessarily amount)
• Potential importance (again) of strong savings
  clause
• (3) Mistakenly paid or made available - the
  ignorant payee
• General rule Taxpayer not in constructive or
  actual receipt of income, even if paid or made
  available, if she doesnt know about it
  (Furstenberg, 83 T.C. 755 (1984) Davis, T.C.
  Memo 1978-12 Single, T.C. Memo 1988-549
• Roberts v. United States, 734 F. Supp. 314 (N.D.
  Ill. 1990).

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Document/Operational Errors Other
Consent-Based Approaches

• (4) Mistaken payment via bad administration of
  deferral election
• Example Bonus amount paid in 2011 despite
  deferral election in 2010
• Notice 2008-113 acceleration failure
• What parties agreed to No failure. Participant
  deferred specified portion of 2011 compensation,
  deferrable from later paid 2011 comp (annual
  income accounting)
• Note Artful drafting could help here
• (5) Mistaken non-payment
• Example Payment due in 2009, mistakenly unpaid
  in 2011
• Notice 2008-113 deferral failure, correctible
  for insider only with tax penalty
• What parties agreed to Payee in constructive
  receipt in 2009. Mistake is tax reporting
  failure, fixed by amending W-2 for 2009
• (6) Mistaken deferral election
• Example Bonus amount deferred in excess of
  Participants deferral election
• Notice 2008-113 failure. Bad deferral,
  correctible under notice
• What parties agreed to No failure. Participant
  did not elect to defer excess. Fixed by
  correcting short paycheck.

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Document/Operational Errors Other
Consent-Based Approaches

• (7) Improper deferral election tougher case
• Example Exec with compensation under three-year
  contract defers Year 2 compensation in December
  of Year 2 bad short term deferral election
• Notice 2008-113 failure subject to correction
• What the parties agreed to Election not
  permitted, fix W-2 for constructive receipt of
  deferred amount