Internal Revenue Code Section 409A (Section 409A) governs the federal income tax treatment of non-qualified deferred compensation and retirement plans and arrangements. Employer noncompliance in both documentation and administration of plans or arrangements subject to Section 409A can lead to harsh results for employees, i.e., accelerated taxes and excise taxes (generally full, immediate income inclusion, a 20 percent additional federal tax, interest during the deferral period of all vested amounts, and, sometimes, additional state tax liability). The rules of Section 409A have been broadly interpreted by regulations to impact almost every type of compensation arrangement, including employment, severance, and change-in-control agreements; short- and long-term equity, incentive, and bonus plans; and other contingent compensation arrangements.
The IRS is beginning a compliance initiative project (CIP) focused on Section 409A compliance with respect to the 10 most highly compensated individuals at 50 large companies (selected from a group of companies previously identified for employment tax audit). The IRS plans to start by issuing Information Document Requests (IDRs) to these companies focusing only on initial deferral elections, subsequent changes in deferral elections, and timing of payouts, including the six-month delay of payment following separation from service to certain employees of publicly traded companies. The CIP is limited but foreshadows a much broader Section 409A enforcement initiative planned by the IRS. Section 409A is complicated, confusing, and often ambiguous. Information gained from these audits will be used by the IRS to target future Section 409A audit and enforcement activity.
We do not yet know the scope of the IDRs planned under the newly announced CIP. The IRS previously released draft Section 409A IDRs that require employers to provide detailed information regarding deferred compensation plans, payments made, and deferral elections. Prior draft IDRs also required employers to take legal positions on whether particular arrangements were covered by Section 409A and to identify any Section 409A violations. This requires key tactical decisions to be made very early in the audit process. Employers being audited need to be very careful regarding the information provided and the legal positions taken to avoid generating tax liability for their employees.
Section 409A corrections procedures are available to help mitigate the harsh Section 409A treatment when documentary or administrative errors are self-discovered and voluntarily disclosed. Taxpayers are generally ineligible for this program if the issues are disclosed after an audit begins, however. It is not yet clear how the IRS might use information from the planned employer audits to assert claims against employees.
Therefore, this is a good opportunity for employers large and small to make sure all of their compensation arrangements comply with Section 409A.