As the IRS steps up its audit activity for compliance on Internal Revenue Code Section 409A, it’s a good idea for businesses to review their deferred compensation plan documents and practices.
The IRS announced last year a limited audit initiative to evaluate compliance with Sec. 409A, which prohibits deferred compensation arrangements that give participants (including employees, directors and independent contractors) undue control over the timing of benefits. Violations can subject participants to immediate taxation of vested benefits plus a 20% penalty and interest.
Congress enacted Sec. 409A more than 10 years ago in response to scandals involving Enron and other corporations. The section applies to most nonqualified deferred compensation arrangements, including bonus plans, supplemental executive retirement plans, certain severance pay plans, and equity-based incentive compensation plans — such as stock options, stock appreciation rights (SARs) and phantom stock.
The requirements don’t apply to qualified retirement plans (such as 401(k) plans) or to most welfare benefit plans (such as vacation, sick leave, compensatory time, disability and death benefit plans). Also exempt are short-term deferrals (bonuses paid within 2½ months after year end, for example) and undiscounted stock options and SARs (see below).
For covered arrangements, Sec. 409A governs the timing of deferral elections and restricts the ability of participants to alter the form or timing of the payments. The law and regulations in this area are complex, but here’s a quick summary of the main requirements:
- Employees must make deferral elections before the beginning of the year in which they earn the compensation being deferred (except for certain performance-based compensation).
- Benefits must be paid either: 1) on a specified date, 2) according to a fixed payment schedule, or 3) upon the occurrence of a specified event, such as death, disability, termination of employment, change in ownership or control of the employer, or an unforeseeable emergency.
- 409A prohibits plans under which the CEO or board of directors has discretion over the timing or form of payment of vested benefits.
- Once compensation is deferred, payments can be delayed (by five years or more) but not accelerated. Elections to delay benefits (or change the form of payment) must be made at least 12 months in advance.
In addition, employers must maintain written plan documentation that’s consistent with Sec. 409A’s requirements.
As noted above, undiscounted stock options and SARs — that is, those with an exercise price that equals or exceeds the stock’s grant-date fair market value — are exempt from Sec. 409A. Because a plan that requires participants to elect in advance when they’ll exercise their rights is unworkable, most stock options and SARs are issued at fair market value to avoid Sec. 409A’s requirements.
The best way to ensure that your plan falls within the exemption is to have your company’s stock valued periodically by a qualified, independent appraiser.
Review your compensation program
Given the complexity of Sec. 409A and its regulations, it’s important to review your deferred compensation plans for compliance. If you discover errors in a plan’s documentation or operations before the IRS commences an audit, you may be able to reduce or even eliminate penalties by participating in one of the IRS’s voluntary correction programs.