3554 / How is the penalty tax under Section 409A calculated?

If it is necessary to compute the worst case scenario, the directions for completing the calculations, including the calculation of the late premium penalty interest, as applicable, can be found in Proposed Treasury Regulation Section 1.409A-4. This proposed regulation for calculation of the tax under Section 409A was issued in December 2008, and was subject to a proposed amendment in 2016 as to the inclusion or exclusion of nonvested amounts under the anti-abuse rule. Both the 2008 and 2016 proposed amendments are still not yet final as of the date of this publication.

One of the positive elements in the calculations under the 2008 proposed regulations was that the calculation applied only to vested benefit amounts unless there was an indication that vesting was being used as a subterfuge to avoid the application of Section 409A. In general, this anti-abuse rule provided that amounts would not be treated as unvested (hence would require inclusion) to the extent there is an indication of a pattern or practice of permitting changes of the time and form of payment on unvested amounts contrary to the rules providing for such changes (primarily the so-called “subsequent election” rule).

The anit-abuse rule has since been made more stringent by proposed 409A technical clarifications regulations released in June, 2016 to address the apparent issue of abusive changes in timing or form of payment being made to plans, especially with long vesting periods. The anti-abuse rule now provides that any unvested amounts will be treated as vested for purposes of income inclusion if there is a change in a plan provision otherwise not permitted by 409A as to time and form of payment and has otherwise to comply with the applicable 409A change rules. To remain unvested, there must be a reasonable good faith basis to conclude: 1) the original provision did not meet 409A requirements, and 2) the change is necessary to bring the plan into compliance with the form requirements. The proposed technical regulations actually provide examples of patterns of permitting impermissible change in time and form of payment, and dictate the appropriate, 409A correction procedure to be applied.¹

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Planning Point: Under this revised anti-abuse portion of the unvested amounts noninclusion exception rule, corrections cannot now made on a SERP design with vesting delayed until nearly retirement (as many SERPs for key employees in closely-held companies are structured), and still be able to make corrections to the plan for errors during nearly the entire period of the plan, if the form correction were made in a tax year prior to the tax year in which separation from service occurred,² without worrying about imposition of a tax under Section 409A. This is because the benefits will be treated as vested, and therefore includible in any calculations for an error, unless the error is discovered at that late date and the change made is necessary to assure compliance. Even then, if the time and form of payment would be changed, the 409A rules for changes in the timing and form of payment would need to be followed, and the appropriate correction procedure must be followed as part of the error correction.

Of course, such plans might be better designed as a plan excepted from 409A coverage entirely, so as to avoid IRS questions on whether the exclusion of unvested amounts will be recognized. Presumably, the IRS would ignore this rule if the plan is drafted outside the requirements of Section 409A, or if there appears to be a pattern of ignoring Section 409A with regard to the plan, or making periodic changes to plan provisions that are not necessary to bring a plan into compliance, or change a provision that is already compliant.

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