Correcting 409A Operational Failures: Notice 2008-113 Relief

Correcting 409A operational failures runs through IRS Notice 2008-113, which lets an employer and employee undo an inadvertent mistake in running a nonqualified deferred compensation plan without triggering the full Section 409A penalties. Those penalties are heavy: immediate taxation of all deferred amounts, a 20% additional tax, and premium interest at the federal underpayment rate plus one percentage point running back to the year of first deferral.¹ The notice tiers its relief by how quickly the error is fixed, and it treats company insiders more strictly than everyone else.

What Counts as an Operational Failure

An operational failure is an inadvertent, unintentional mistake in carrying out a plan whose written terms already comply with Section 409A.² Typical examples: paying out a deferred amount too early, missing a scheduled deferral from an employee’s paycheck, or failing to apply the six-month payment delay for a specified employee at a public company.

If the problem is with what the plan document actually says, that’s a document failure, and the correction path runs through IRS Notice 2010-6 instead.³ Using the wrong notice means the correction isn’t recognized and the full penalties stay in play.

Who Qualifies to Use the Relief

The employer has to be able to show the error was genuinely inadvertent and unintentional, and that the company took commercially reasonable steps to avoid it in the first place.² The notice doesn’t define “commercially reasonable,” but documented compliance procedures, trained payroll staff, and periodic audits of deferred compensation transactions all help. A company with no controls at all has a much weaker argument that any failure was inadvertent.

For corrections made after the taxable year of the failure (under Sections V through VIII of the notice), the affected employee’s federal return for the year of the failure must not be under IRS examination at the time of the correction.² Once the return is under audit, that door closes. Same-year corrections under Section IV are not subject to this examination restriction, which is one more reason to move fast.

The relief is also unavailable if the correction is being used to manipulate the timing of income into a lower-tax year rather than to fix a real mistake.

The Correction Windows

Relief comes in tiers. The sooner the fix, the fuller the relief.

Same Taxable Year

If the failure is caught and corrected within the same taxable year it happened, the fix is available to everyone, insiders included. For an erroneous payment, the employee repays the amount plus any earnings generated while the funds sat outside the plan. For a missed deferral, the employer contributes what should have been deferred and credits the account with the gains or losses it would have earned. Everything has to be completed by the last day of the employee’s taxable year in which the failure occurred.² Because the whole thing lands in one tax year, no amended returns or multi-year reconciliations are needed.

Next Taxable Year, Non-Insiders Only

If the failure isn’t caught until the following year, a second tier is available, but only for employees who were not insiders at any point during either the year of the failure or the following year.² The correction has to be completed by the last day of the employee’s taxable year immediately following the year of the failure. The same repayment-plus-earnings mechanics apply, but the math gets more involved because investment returns over a longer period have to be reflected. Insiders are shut out of this tier entirely.

Later Corrections

For certain failures involving limited dollar amounts or specific other operational errors, relief is still available if all requirements are met by the end of the second taxable year following the year of the failure.² This tier is narrower. It typically requires including some portion of the affected compensation in the employee’s income, along with additional tax consequences that fall short of the full 409A penalty but aren’t zero. This is the last chance before statutory penalties apply in full.

The Special Rules for Insiders

The notice defines an insider as any director or officer of the company, or anyone who directly or indirectly owns more than 10% of any class of the company’s equity securities, using the SEC’s rules under Section 16 of the Securities Exchange Act of 1934.² That definition catches more people than employers often expect. A vice president with no stock still counts as an insider by virtue of the officer title.

Insiders who miss the same-year window have a much narrower path forward. The next-year tier is closed to them. They can only rely on the limited-amount or other-failure provisions, which carry tighter conditions and less generous outcomes.² Track who counts as an insider through the year, because a mid-year promotion or stock purchase can change someone’s status and eliminate a correction option that seemed available.

Calculating What’s Owed

Every correction has to put both sides back where they would have been if the mistake never happened. That means tracing the money through the plan’s actual investment options.

When an employee received an erroneous early payment and has to repay it, the notice requires interest on the repayment at no less than the short-term applicable federal rate under Section 1274(d)(1), annually compounded, for the month the erroneous payment was made.² The employee returns the original amount plus that interest, so the time value of the early payment is neutralized.

When the employer missed a deferral, the account has to be credited with whatever gains or losses the plan’s investment options would have produced during the gap. If the plan tracks a specific mutual fund or index, the adjustment follows it. For late payments owed to employees, the employer may pay reasonable interest to compensate for the delay, though the notice doesn’t set a specific rate for payments going that direction.² If the plan’s investments lost value during the error period, the correction is reduced accordingly. The employee bears the same market risk they would have carried had everything been done right.

Executing the Correction

Once the numbers are settled, the mechanics involve moving funds and adjusting records. For an erroneous payment, the employee returns the net after-tax amount to the employer, and the employer reconciles the previously withheld taxes against future withholding or through other adjustments. The plan ledger has to show the returned funds as if the distribution never happened.

For a missed deferral, the employer contributes the calculated amount, adjusted for earnings or losses, into the employee’s account. Those entries need to be separated from ordinary current-year contributions so they can be identified later as corrections.

Documentation matters at every step: payroll records showing the original error, bank statements confirming the transfers, ledger entries tracking the adjustment, and records of the employee’s tax withholding at the time. If a prior-year payment is involved, a corrected Form W-2 may be needed. All fund transfers have to be finished before the deadline for the relief tier being used.

Reporting the Correction to the IRS

Fixing the money is only half of it. The employer has to attach a correction statement to its federal income tax return for the year the correction was made. That statement must include the name and taxpayer identification number of each affected employee, whether the employee is an insider, a description of the operational failure, the dollar amount, the date of the failure, and the section of Notice 2008-113 being relied on for relief.²

The affected employee attaches a similar statement to their own return. To make that possible, the employer has to give the employee all the information needed for the employee’s statement by the end of the year in which the correction is made.² The employee notice should identify the specific relief provision being claimed and describe the corrective steps taken.

There is no dedicated IRS form for the correction statement. The attachment just has to follow the format the notice describes and be labeled clearly enough that IRS processing staff can identify it as a 409A correction. Keep copies of every statement filed and proof of submission. Those records are the primary defense if the IRS later questions the correction during an audit.

1
Office of the Law Revision Counsel. 26 U.S. Code 409A – Inclusion in Gross Income of Deferred Compensation
2
Internal Revenue Service. IRS Notice 2008-113
3
Internal Revenue Service. IRS Notice 2010-6 – Relief and Guidance on Corrections of Certain Failures of a Nonqualified Deferred Compensation Plan to Comply with 409A(a)