409A Failures: Correcting Outside of The IRS’s Formal Correction Programs

1. 409A Failures: Correcting Outside of The IRS’s Formal Correction Programs Rosina B. Barker Ivins, Phillips & Barker 1700 Pennsylvania Ave., N.W. Washington, DC 20006 (202) 662-3420 rbarker@ipbtax.com DC Bar Luncheon Program February 25, 2010 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.

2. 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

3. 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

4. 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

5. 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”

6. 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 Congress’s 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

7. 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)).

8. 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 • What’s 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

9. Document Errors – Correcting the Contract 4 • [Intrinsically ambiguous documents, cont.] • IRS’s 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) (rev’g 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

10. Document Errors – Correcting the Contract 5 • Non-ambiguous document – Scrivener’s 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

11. Document Errors – Correcting the Contract 6 • Extrinsic ambiguity for 409A doc interpretation • What’s 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) aff’d 9th Cir.

12. 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?

13. 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 statusquo ante rule bar doctrine’s application to compensation? • Apparently not - • Status quo ante rule can’t 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 )

14. 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?

15. Document/Operational Errors – Other Consent-Based Approaches • General Principle: Obligee is not in actual or constructive receipt of income he doesn’t want, hasn’t agreed to get, and doesn’t 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

16. 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?

17. 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 doesn’t 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).

18. 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 Participant’s 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.

19. 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