Executive Summary: At the American Bar Association Section of Taxation 2014 May Meeting, an IRS official announced that the IRS has created a compliance initiative project (CIP) for Section 409A of the Internal Revenue Code (IRC). As part of the CIP, the IRS will review the deferred compensation plans of selected employers to evaluate their compliance with Section 409A requirements.
Section 409A governs the timing of deferral elections, permissible distribution events, and the timing of tax inclusion for most nonqualified deferred compensation arrangements. Nonqualified deferred compensation is defined as any plan or arrangement where a service provider (e.g., employee, director, independent contractor) has a legally binding right during a taxable year to compensation that is or may be payable to the service provider in a later year.
If the requirements of Section 409A are not satisfied:
- Then all compensation deferred under the arrangement is includable in the service provider's gross income to the extent that the compensation is not subject to a substantial risk of forfeiture or is not subject to certain exemptions.
- The service provider will be required to pay interest at the federal underpayment rate plus one percentage point from the time the amounts should have been included in the service provider's income.
- The service provider will incur a 20 percent penalty on the amount required to be included in income.
The CIP will be limited to 50 specific large employers and focus on:
- Initial deferral elections;
- Subsequent deferral elections; and
- Payouts under Section 409A, including the six-month delay for specified employees.
The CIP will also be limited to the 10 highest paid employees of each of the employers selected for participation.
While the 409A CIP is limited in scope, it is expected that the IRS will use the CIP to determine the most common areas of non-compliance and sharpen its audit techniques for future audits. Accordingly, employers, especially those whose plans have not been reviewed since 2008, should have all their nonqualified deferred compensation plans reviewed for operational and documentary compliance with Section 409A.
By doing so, employers will be able to identify Section 409A violations and be eligible to voluntarily correct the violations under the Section 409A Voluntary Correction Program. Once the plan, employer, or executive is under audit, however, the plan will not be eligible to voluntarily correct for any Section 409A operational or documentary violations, and the plan participants may be subject to immediate taxation of all vested deferred amounts and the Section 409A 20 percent penalty.