This is the seventh in a series of “Spring Cleaning” alerts. As part of this series, we will provide you with various to-do items and tips in the employee benefits, employment, and immigration areas.
The IRS recently announced a new Section 409A audit initiative targeting large and international companies. The IRS audit initiative will focus on the top ten highest paid individuals at the audited companies and will include all forms of nonqualified deferred compensation offered to those ten individuals. The IRS has indicated that it will pay particular attention to initial deferral elections, subsequent deferral elections, and distributions, including the six-month delay (if applicable). This alert will give you tips on how to make sure your company’s 409A house is clean should the IRS arrive for audit.
The concept of deferred compensation is extremely broad under Section 409A. Any agreement to pay compensation or provide benefits in future years is potentially subject to Section 409A, including traditional deferred compensation plans, equity compensation plans, bonus plans, employment contracts, and severance plans.
Section 409A imposes a comprehensive set of deferral and payment rules relating to the taxation of deferred compensation arrangements. The primary requirements under Section 409A are: (a) elections to defer compensation must be made irrevocably in the year before the services are performed to which the compensation relates (with some leeway for new plan participants and “performance-based compensation”), (b) deferred compensation may only be paid upon the occurrence of certain specified events, and (c) the deferred compensation payments may not be accelerated. While these requirements might appear simple on the surface, the fact that the IRS has issued hundreds of pages of guidance suggests otherwise.
Section 409A created severe penalties for the service provider (i.e., the employee or director) if a deferred compensation arrangement fails to comply with the detailed Section 409A requirements. These penalties include a 20% additional income tax, interest on underpaid taxes, and the acceleration of taxable income once the award is no longer subject to a substantial risk of forfeiture. Although the tax consequences apply to the employee or other service provider, companies will want to make sure that their deferred compensation arrangements comply because of potential related exposure, e.g., due to employee claims against the employer, employer withholding and reporting noncompliance, and the allocation of Code Section 409A risks/costs in future M&A or other transactions.
Plans that do not comply with Section 409A may be able to correct errors under IRS correction programs. There are two formal IRS correction programs for Section 409A errors, which cover a range of errors and offer reduced/eliminated penalties for sponsor self-corrections (but that require action before an audit is commenced):
- IRS Notice 2008-113 established a correction program with regard to “operational” failures to comply with Section 409A. An operational error occurs, for example, if a payment is accelerated into an earlier year than permitted by the plan document.
- Notice 2010-6 and Notice 2010-80 established a Section 409A correction program that permits a plan sponsor to correct many types of “document” failures relating to Section 409A of the Internal Revenue Code. A “document” failure generally relates to a provision in a deferred compensation arrangement that does not satisfy the Section 409A requirements.
Q&B Key: In light of the increased enforcement efforts regarding Section 409A, employers should review their existing deferred compensation arrangements to address potential documentation or operational issues. Such steps should include:
- Identifying all arrangements that provide for Section 409A deferred compensation;
- Identifying all deferral and distribution elections under the arrangements;
- Reviewing the arrangements and their operation for compliance with the documentation requirements of Section 409A;
- Amending each arrangement, as necessary, to comply with the rules in accordance with IRS regulations and any available correction problems; and
- Reviewing operational compliance with Section 409A and correcting where necessary.