The Internal Revenue Service announced in November of 2009 that in February 2010, it would begin its first Employment Tax National Research Project since the 1980s. This Tax Project will include audits of 6,000 companies over the next three years, and is expected to focus review on (among other issues) executive compensation, including deferred compensation arrangements subject to Section 409A of the Internal Revenue Code of 1986, as amended.
In addition, employers are now reporting that the IRS has begun to audit deferred compensation plans for compliance under Section 409A. These audits are being conducted by the IRS as a separate audit project quite apart from the Tax Project. The IRS has been issuing “Information Document Requests” (IDRs) requiring disclosure of specific information on deferred compensation arrangements subject to Section 409A. These IDRs will be used to determine whether these arrangements are in compliance with Section 409A.
Section 409A contains complex rules relating to the timing and form of payment of deferred compensation. Arrangements providing deferred compensation must be in a writing that conforms to 409A requirements (i.e., documentary compliance) and operated in compliance with the plan document and Section 409A. An operational and/or documentary violation of Section 409A can subject the recipient of the compensation to immediate income inclusion of deferred amounts (even before the amounts are paid to the recipient) as well as an additional 20% tax and interest (409A Penalties).
Documentary compliance with Section 409A was required as of January 1, 2009. Failure to meet this deadline would normally result in the imposition of 409A Penalties. However, compliance with Section 409A continues to be a “work in progress” as companies and their advisors continue even now to struggle to understand the complexities of some of these new rules.
In recognition of this fact and as an incentive for employers to revisit their earlier good faith efforts to comply, the IRS issued recently Notice 2010-6 (Correction Notice) which sets forth methods for correcting certain documentary failures. Normally, even where the Correction Notice is followed, the payment of a partial 409A Penalty is required. However, the special “transition relief” offered under the Correction Notice provides that certain corrections to non-conforming plan documents may be made by the end of 2010 (and in some cases by the end of 2011) without the imposition of any 409A Penalty.
Sponsors of deferred compensation plans should review their plans now to determine whether documentary corrections are indicated. This is true even for plans that have already been amended under 409A by the January 1, 2009, deadline. Much has happened in the world of 409A since that time, and new understandings of the rules may require additional changes to plan documents. The Correction Notice offers for a brief period the possibility of making corrections without the imposition of 409A Penalties. But it is important to act before a plan comes under audit. Transition relief without penalties is generally not available with respect to identified 409A failures under examination by the IRS.