The IRS has a mandate to protect the tax base, and Section 409A provides it with the breadth of reach and penalties that should not be taken lightly. Vigorous IRS audits for compliance in this area should motivate companies to review employment agreements and compensation plans for compliance with Section 409A.
What is IRC Section 409A?
Section 409A of the Internal Revenue Code applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation, defined as any plan or arrangement where a service provider (e.g., employee, director or 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. Nonqualified deferred compensation differs from deferred compensation in the form of elective deferrals to qualified plans such as 401(k), 403(b) or 457(b) plans.
How does coverage under Section 409A affect an employee’s taxes?
Section 409A imposes restrictions on the deferral of compensation by employees, directors and other independent contractors (collectively, “employees”). It was enacted as a response to executives controlling the timing of compensation recognition (i.e., the Enron bankruptcy where millions of dollars in payouts were recognized shortly before the bankruptcy filing). Deferred compensation under Section 409A potentially includes any arrangement under which an employee has a right to receive compensation earned in one tax year and paid in a subsequent tax year. This can include retirement plans, bonus plans, incentive compensation plans, severance arrangements, stock option plans, stock appreciation rights, phantom equity plans and individual employment agreements.
If deferred compensation meets the requirements of Section 409A, then there is no effect on the employee’s taxes. The compensation is taxed in the same manner it would be taxed if it were not covered by Section 409A. If the arrangement does not meet the requirements of Section 409A, the compensation is subject to certain additional taxes, including a 20% additional income tax.
Until recently, Section 409A audit activity occurred as part of an examination of an employer’s tax return. At the American Bar Association Section of Taxation May 2014 meeting, an IRS official announced that the IRS has created a compliance initiative project (CIP) for Section 409A of the 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. “A compliance initiative project has been created for Section 409A,” said Thomas D. Scholz, IRS senior technician reviewer, Office of Division Counsel/Associate Chief Counsel, Tax Exempt and Government Entities. The audits will be conducted by the IRS’s Small Business/Self-Employed (SB/SE) Division.
The IRS said the project will be conducted through standard “information document requests” (IDRs) and will focus on three broad issues: initial deferral elections, subsequent deferral elections and payouts under Section 409A (including compliance with the six-month delay for specified employees). To limit the burden on the audited companies, the IRS said the scope of the audit will focus on the top 10 highest paid employees at the audited companies, and will be limited to the deferral elections and distributions for the years under examination. This program is seen by many as a first step in a process that will allow the IRS to develop audit techniques and areas of inquiry before the program is expanded to more employers. Targeted IRS examinations for compliance with IRC Section 409A have been anticipated for years. We are likely seeing the first phase of an ongoing 409A enforcement initiative.
Penalty for Noncompliance
Section 409A governs the timing of deferral elections, permissible distribution events, and the timing of tax inclusion for most nonqualified deferred compensation arrangements. If the requirements of Section 409A are not satisfied:
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% penalty on the amount required to be included in income.
Valuation Matters for Closely Held Businesses
Stock Option and Stock Appreciation Rights (SAR) Plans - These provide the recipient the ability to realize appreciation of value over a set period of time. Unlike a stock option, SAR plans typically do not include an exercise price (cost), but rather benefit from the appreciation of a stock’s value. While stock option and SAR plans are exempt from Section 409A, nonpublic companies must meet specific requirements in order for their plans to be exempt from Section 409A. Failure to comply with Section 409A regulations pertaining to value, deferral election, payment restriction, and timing and form of distributions may subject the income on exercise to the 20% penalty tax under Section 409A.
Phantom Stock Awards - While SARs may be structured to avoid falling within the limits of Section 409A, phantom stock is deferred compensation, subject to Section 409A. Immediate award payments upon vesting could be used to avoid Section 409A restrictions, thus meeting the short-term deferral rule (generally payment within 2½ months after the end of the tax year in which vesting occurred).
Discretion of Board or Executive Officer over Payments - Section 409A prohibits discretion by boards of directors or management as to timing or form of payment.
Once a company or an executive is under an IRS audit on these issues, the IRS correction programs are no longer available. 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., employee claims against the employer, employer withholding and reporting noncompliance, and the allocation of related risks/costs associated with plans.