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August 26, 2014

2014-Issue 34—Just before summer, the IRS spoke unofficially about a new audit initiative covering Section 409A compliance for deferred compensation. This appears to be the first organized audit initiative specifically geared at Section 409A compliance since the legislation was enacted nearly a decade ago as a result of several corporate scandals and perceived abuses by executives in the early 2000s. Although this audit initiative is limited in scope, the IRS will use this practice round to hone its skills and identify common areas of non-compliance. Accordingly, other companies should take some time now to clean house before the IRS expands its audit focus. This edition of Tax Advisor Weekly provides an overview of Section 409A and the IRS audit initiative, discusses some of the errors we commonly see in deferred compensation arrangements, and details what companies can do now to fix mistakes before it is too late.

Overview of Section 409A

Section 409A applies to nonqualified deferred compensation plans, which are defined as any plan that provides for the deferral of compensation other than a qualified employer plan, any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. This definition is broad and can be complex to apply in practice. Arrangements potentially subject to Section 409A include everything from severance plans to equity arrangements to reimbursement programs, just to name a few. A plan must provide for compensation deferred to be paid only upon one (or the earlier/later of several) of the following events:

  • A fixed date;
  • Separation from service;
  • A change in ownership or control;
  • Disability;
  • Death; or
  • An unforeseeable emergency.

Non-compliant deferrals will become immediately taxable once vested and hit with an additional tax of 20 percent plus interest. Accordingly, it is important for companies to correct deferred compensation plans with form or operational failures to avoid having their employees face these stiff consequences.

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