A deferred compensation plan can be written correctly and still fail in operation: a bonus paid in March instead of April, a deferral election that payroll never processed, a payment made on separation without the required six-month delay. Section 409A taxes the employee, not the company, which makes a late discovery painful for both. Notice 2008-113 gives a way to fix certain operational failures without full tax consequences, if the company acts within the notice's windows. The valuation side of equity pay is covered in the 409A valuation guide.
What a failure costs
Under section 409A(a)(1), if a nonqualified deferred compensation plan fails the requirements, the amounts deferred for the year and all preceding years, to the extent not subject to a substantial risk of forfeiture and not previously included in income, are includible in gross income for the year. The tax is increased by interest at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the compensation been included when first deferred, and by an additional tax equal to 20 percent of the compensation required to be included. The company has reporting and withholding exposure.
What the notice offers
Notice 2008-113 provides relief and guidance for correcting certain failures to comply with section 409A(a) in operation. The relief is organized by how fast the company acts:
- Section IV, same taxable year. An erroneous payment is repaid by the end of the service provider's taxable year, and the amount is treated as timely deferred. The repayment is not income and is not reported on Form W-2 or Form 1099. Section IV covers a failure to defer or an incorrect payment of an amount payable in a later year (IV.A), a payment made more than 30 days before its due date in the same year or a payment inside the six-month delay for a specified employee (IV.B), and excess deferrals (IV.C).
- Section V, following taxable year, non-insiders only. The same kinds of failures can be repaid by the end of the next taxable year, but the original payment is included in income and reported on Form W-2 or Form 1099 for the year paid. The service provider deducts the repayment (not the interest) in the repayment year.
- Section VI, limited amounts. If the erroneous payments in the year do not exceed the section 402(g)(1)(B) elective deferral limit, only the amount that should have been deferred is includible, and the service provider owes the 20 percent additional tax but not the premium interest tax.
- Section VII, other failures. Repayment is due by the end of the second taxable year after the failure. Only the amount that should have been deferred is includible, the 20 percent additional tax applies, the premium interest tax does not, and an insider pays interest at no less than the short-term applicable federal rate. The amount is reported with Code Z in box 12 of Form W-2.
Sections VI and VII require all steps, including any amended return, to be completed by the end of the service provider's second taxable year after the year of the failure.
Eligibility rules that apply to every correction
Section III sets the conditions:
- The service recipient takes commercially reasonable steps to avoid a recurrence. If the same or a substantially similar failure occurred before, relief for taxable years beginning after December 31, 2009 requires showing that practices reasonably designed to prevent it were in place and the failure happened despite diligent efforts.
- Sections V through VIII are not available if the service provider's federal return for the year of the failure is under examination with respect to the plan.
- The failure must be inadvertent and unintentional. Relief does not cover plan document failures, exercises of stock rights that would fail 409A, or listed transactions.
- Relief is not available for erroneous payments in a year when the service recipient has a substantial financial downturn that indicates a significant risk it cannot pay the deferred amount when due.
- The service recipient attaches a statement titled "409A Relief under [section] of Notice 2008-113" to its timely filed return and gives each affected service provider a statement by the date Form W-2 or Form 1099 is due (section IX).
Who is an insider
The notice defines an insider as a director or officer of the service recipient, or a direct or indirect beneficial owner of more than 10 percent of any class of equity security, determined under the SEC's Section 16 rules, whether or not the company has registered equity securities. For the section V correction, relief is not available for a service provider who is an insider at any time during either the year of the failure or the following year. In section IV.A, an insider whose erroneous payments exceed the 402(g)(1)(B) limit pays interest at no less than the short-term AFR, computed as the amount times the rate times days outstanding divided by days in the year.
Repayment mechanics
For an erroneous early payment, the service provider repays by the end of the year of the payment (section IV) or during the following year (section V), and then has a legally binding right to the amount at the time and in the form it would have been payable. If the amount would have been payable under the plan during the year in which repayment is due, no repayment is required, but the service provider pays interest at no less than the short-term AFR, using the first date in that year the amount could have been paid as the repayment date. If repayment would cause an immediate and heavy financial need as defined in the 401(k) hardship regulations, the parties may agree to a schedule ending not later than 24 months from the due date, without extensions, of the return for the year of the erroneous payment. In section IV.A that option is limited to non-insiders.
Worked example: next-year correction
A company's plan says a non-insider manager's $60,000 deferred bonus is payable on March 1, 2027. Payroll pays it on December 15, 2026, in error, and the company discovers this in January 2027. The same-year window under section IV is closed.
- The failure is an incorrect payment of an amount payable in a later year, so section V.B applies. The manager is not an insider in 2026 or 2027.
- The original payment date, March 1, 2027, falls in the year repayment would be due, so no repayment is required.
- Interest uses the short-term AFR for December 2026, compounded at year end. Assume 4.0 percent. For 2026: $60,000 times 4.0 percent times 16 over 365 days is $105.21. For 2027, on $60,105.21: times 4.0 percent times 60 over 365 days (January 1 through March 1) is $395.21. Total interest is $500.42.
- The $60,000 is included in the manager's 2026 income and reported on the 2026 Form W-2.
- Without correction, the 20 percent additional tax on $60,000 is $12,000, plus premium interest at the underpayment rate plus 1 percentage point.
If the manager owned 12 percent of a class of the company's equity, the manager would be an insider and section V would not be available.
Worked example: same-year correction
The notice's own illustration of section IV.A: a non-insider elects to defer 50 percent of a $100,000 bonus, and the employer defers only $10,000 and pays $90,000, including $40,000 that should have been deferred. The deferral is treated as timely if, by December 31 of the year, the additional $40,000 is credited to the account and the employee repays $40,000. The $40,000 is not income to the employee and is not reported on Form W-2. If the $10,000 would have earned 10 percent, the account may also be credited $4,000 of earnings ($40,000 times 10 percent), for a $55,000 balance.
Common errors
- Missing the December 31 deadline for section IV and then treating section V as automatically available.
- Applying section V to an officer or a more-than-10-percent holder.
- Omitting the statements to the return and to the employee required by section IX.
- Correcting a failure while the employee's return for that year is under examination.
Client steps
- Maintain a plan inventory that covers bonus deferrals, severance and equity arrangements. Equity grant pricing is covered in the 409A valuation guide.
- Monitor payment dates against plan terms each quarter.
- When a failure is found, record the date of discovery, identify insiders, and decide on the correction before the window closes.
- Attach the required statements to the returns and coordinate reporting with W-2 and 1099 deadlines and corrections.
- For stock-based awards, see ASC 718 for private companies.
Sources
- Internal Revenue Service, Notice 2008-113: https://www.irs.gov/pub/irs-drop/n-08-113.pdf
- Legal Information Institute, 26 U.S.C. 409A, Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans: https://www.law.cornell.edu/uscode/text/26/409A
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