IRS Launches 409A Audit Initiative

Jan 27, 2016

Last month, the Internal Revenue Service announced during an American Bar Association meeting that a Compliance Initiative Project (CIP) was underway, involving compliance with Internal Revenue Code Section 409A. The CIP involves fewer than 50 (mostly larger) employers that had already been identified for employment tax audits and that were likely to have non-qualified deferred compensation plans.

According to Thomas D. Scholz, a senior technician reviewer in the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities), the CIP will focus on three issues:
  • Initial deferral elections
  • Subsequent deferral elections
  • Plan distributions (including compliance with the six month delay for specified employees)
The CIP will likely be limited to elections made by and distributions made to a company’s top 10 most highly-compensated employees during the tax years under review. The purpose of the CIP is to determine the level of compliance with Code Section 409A and the effectiveness of existing audit techniques.

Code Section 409A imposes a number of restrictions on non-qualified deferred compensation plans. A failure to comply with those rules can have significant adverse tax consequences for affected participants. There are two correction programs that may be used to reduce or eliminate those adverse tax consequences. However, the program for addressing operational compliance issues is not available if the participant’s federal tax return for the year of the failure is under examination. The program for addressing document compliance issues is not generally available if the participant’s or the employer’s tax return is under examination for the year of the failure. 

Because the CIP is likely to lead to broader audits involving compliance with Code Section 409A, and because correction programs are typically not available once an audit is underway, now is a good time to review whether your non-qualified plan complies with all of the Code Section 409A rules as well as related tax rules. 

A comprehensive review should cover the following issues:
  • Ensuring that all material terms of the plan are set forth in writing and that none of the plan’s provisions are at odds with the rules of Code Section 409A. The plan document should:
    • Describe the conditions under which employees can make deferral elections and the conditions under which employees can modify distribution elections.
    • Prohibit payments to specified employees sooner than six months following separation from service (if the employer’s stock is publicly traded).
    • Limit payment events to those permitted under Code Section 409A (separation from service, death, disability, change in control, unforeseeable emergency, and specified date).
    • Not provide that payment will be made more than 90 days after a permissible payment event.
    • Not condition payment upon the employee’s execution of a non-compete agreement, a non-solicitation agreement, a release of claims, or similar documents.
  • Ensuring that amounts deferred to the plan are not deducted on the employer’s tax return until those amounts are includible in employee income.
  • Ensuring that deferrals to the plan have been properly reported as FICA and FUTA wages at the appropriate time.
  • Ensuring that distributions are properly reported as income and that applicable income taxes have been withheld from distributions.
  • Ensuring that an employee’s deferrals to the plan are not affected by whether the employee does or does not contribute to a qualified 401(k) plan.
  • Ensuring that elections to defer compensation are timely made and that payroll deductions match the deferral elections.
  • Ensuring that changes to payment elections are timely made and otherwise comply with the subsequent deferral election rules.
  • Ensuring that distributions are made in the correct amount and at the appropriate time.
The Newport Group has published several white papers that provide more information regarding many of the issues noted above. These white papers are available to our clients without cost. Our staff is also available to assist with 409A Compliance Reviews and 409A Remediation of compliance failures for a negotiated fee. 

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