The Internal Revenue Service ("IRS") recently announced that, beginning in February 2010, it will randomly audit 6,000 companies on employment tax issues in connection with executive compensation as well as other areas. In addition to these audits which may touch on issues relating to section 409A of the Internal Revenue Code ("Code"), the audit activity on Code section 409A ("409A") appears to be increasing based on the number of companies receiving 409A related Information Document Requests ("IDRs"). Generally, these IDRs require audited companies to divulge detailed information with respect to their plans and arrangements, deferral elections, and payments that are or may be subject to 409A. This Code section imposes requirements on nonqualified deferred compensation arrangements that are complex and often difficult to administer. Thus, many companies are exercising caution when reviewing and making determinations under their executive compensation arrangements subject to 409A.
Code section 409A - enacted in October 2004 in the wake of Enron and other corporate scandals - applies to a wide range of deferred compensation arrangements (e.g., nonqualified retirement plans, severance agreements, annual bonus arrangements, and long-term incentive plans). Some of the requirements under 409A include: (i) limitations on the time and form of distributions, (ii) rules regarding the timing of deferral elections, (iii) certain restrictions on funding relating to offshore trusts, financial health triggers, and "at risk" defined benefit plans. If a violation of section 409A occurs with respect to an executive's benefits under a deferred compensation arrangement, generally all vested 409A amounts under the arrangement and all similar arrangements are taxed to the executive immediately. The executive must also pay a 20% additional tax on the amount of compensation included in his income plus interest.
In light of the IRS's audit activities and the significant penalties for non-compliance, companies should take special care to ensure their nonqualified deferred compensation arrangements are 409A compliant. In particular, a few basics that companies may wish to review during the operation and administration of their nonqualified deferred compensation arrangements include:
- Review and confirm the correct timing for all payments from plans and arrangements subject to 409A each year.
- Revise any non-compliant deferred compensation arrangements before the year of vesting.
- Avoid making any "in lieu of" payments in substitution for a forfeited 409A amount that would otherwise have been paid at a later time.
- Review all deferral elections for compliance with the 409A rules (e.g., the performance-based compensation requirements).
If errors are discovered during this type of review, some operational errors can be corrected under the IRS correction program, and special relief is available in 2009 for certain operational errors prior to 2008. Additionally, recent comments from government officials indicate that the IRS could unveil a 409A correction program for document errors in the near future.
As you are likely aware by now, compliance with 409A is complex, and companies should consult with counsel to ensure that their nonqualified deferred compensation arrangements are consistent with the requirements under 409A prior to an audit.
Jeffrey W. Kroh and Dionne Benjamin
Groom Law Group