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Internal Revenue Code Section 409A: Compliance Is Critical

March 29, 2017 | Edward Kim

Edward Kim | Consulting Senior Manager

Ed offers clients almost 15 years of experience in executive compensation consultation, including roles at Bank of America, Inc. and one of the top-10 law firms in the nation (as ranked by Vault). He’s counseled...

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Deferred compensation and other plans where compensation is earned in one year but paid in a future year must comply with Section 409A of the Internal Revenue Code, which governs the federal income tax treatment of such plans. Section 409A is the subject of a lengthy and complex body of law that presents many traps and potential penalties for the unwary. Additionally, in 2014, the IRS announced that it would be performing audits involving taxpayer compliance with Section 409A, thus increasing the risks for noncompliance. Since this audit initiative is well underway, now would be a good time to review whether your plans comply with Section 409A.

Plans Covered by Section 409A

Section 409A generally applies to plans where compensation earned in one year is paid in a future year. These plans are often implemented in order to promote retirement savings beyond the limits imposed under the Internal Revenue Code.  However, Section 409A can also apply to other plans where the payment of compensation is delayed past the year it’s earned.  

Plans that are subject to Section 409A include, but are not limited to, the following:
  • Nonqualified deferred compensation plans
  • Supplemental executive retirement plans
  • Phantom equity plans
  • Discounted stock option and stock appreciation awards (i.e., exercise price below fair market value at grant)
  • Certain severance plans and agreements
  • Certain retention plans and agreements

Penalties and Participant Claims

Section 409A imposes several restrictions on these plans, which primarily revolve around the timing of the deferral and distribution dates but also cover other aspects of such plans. Failure to comply with these rules can have substantial adverse impacts on both the company and the plan participants. These penalties include:
  • Immediate income recognition of the participant’s entire plan balance (the “taxable amount”) with respect to the year of error to the participant
  • Potential late payment penalties and interest on the taxable amount to the participant
  • Additional 20% excise tax on the taxable amount to the participant
  • Additional premium interest tax on the taxable amount to the participant
  • Potential late penalties and interest on failure to withhold to the company
  • Restating and refiling previous years’ tax forms (e.g., Forms W-2 and 1099 for companies and Form 1040 for plan participants)
As indicated above, penalties under Section 409A are primarily assessed on the participant. However, if the Section 409A failure occurred as a result of the company’s error, which comprises the vast majority of Section 409A errors in our experience, it is highly likely that the participant would have a claim against the company and seek damages to make whole his or her additional tax liability (i.e., a gross-up payment).   

Why Catching Errors Early Is Critical

It is critical to understand that if certain errors are caught early enough (i.e., within two calendar years following the year of error), there is an IRS correction program (under IRS Notice 2008-113) that can minimize or even eliminate the penalties discussed above. This correction program doesn’t cover all types of errors but does cover the most commonly identified errors, such as failure to defer, early payments, excess deferrals, and late payments.  However, once the company or the participant is subject to an audit on these issues, the correction program is no longer available. Therefore, it is important to get in front of these errors and correct them so there is minimal impact as opposed to getting assessed with severe penalties under an audit. 

Take, for example, a biotechnology company whose research manager has a $500,000 aggregate plan account balance. If a Section 409A error valued at $50,000 occurs, with an applicable 2% AFR interest rate, the following table illustrates the dramatic difference in penalties and filing requirements depending on when and if an issue is proactively addressed:
 
Scenario  Approximate Penalty Additional Filing Requirement(s)
Corrected within same plan year $0 IRS Attachment to Employer Tax Return
Corrected within one year following year of error $1,700 IRS Notice from Employer to Participant
IRS Attachment to Employer & Participant Tax Returns
Corrected within two years following year of error $17,000 IRS Notice from Employer to Participant
IRS Attachment to Employer & Participant Tax Returns
Amended Participant Tax Returns
Not proactively corrected.
Assessed in IRS audit.
$221,000 IRS Notice from Employer to Participant
IRS Attachment to Employer & Participant Tax Returns
Amended Participant Tax Returns
Amended Forms W-2/1099

Typical Scope of Review

Section 409A is multifaceted and might have different requirements for a specific type of plan. As such, plan review involves an individualized approach. However, a review should generally be designed to achieve and ensure the following:
  • Deferral elections and distribution elections are made in a timely fashion (including documentary evidence)
  • Payroll deductions or contributions match the deferral elections
  • Deferrals to the plan have been properly reported as FICA and FUTA wages at the appropriate time
  • Deferral cancellations mid-year for continuing employees conform with Section 409A “permissible events” 
  • Distributions are only made on account of events permitted under Section 409A
  • Delays in distribution comply with the subsequent deferral rules or other exceptions (including documentary evidence)
  • Distributions are properly calculated and recorded as income and applicable income taxes have been withheld from distributions
  • Distributions made on account of unforeseeable emergencies comply with Section 409A requirements
  • Amounts paid to “specified employees” are made no earlier than six months following a separation from service (public companies only)
  • Investment or interest accruals are accurately recorded in accordance with the participant’s investment elections or interest rate
  • Plan document and amendments review to confirm compliance

Key Takeaways

If you are an employer who sponsors a deferred compensation plan or other plan subject to Section 409A, now would be a great time to review your plan’s administration to determine whether the plan is in compliance with Section 409A and, if not, to take steps correcting errors that can minimize or eliminate IRS imposed penalties. Given the high stakes for noncompliance and the IRS Section 409A audit initiative, ignoring compliance can be a monumental affair in terms of cost, time, and employee morale.  Benjamin Franklin’s old adage “an ounce of prevention is worth a pound of cure” could not be more appropriate in describing this matter. 

EKS&H’s compensation and benefits team helps companies perform plan reviews through agreed-upon procedures. This can help you identify any areas of noncompliance so you can take action in correcting them in advance and prevent any serious consequences by audit.  For more information, please contact Edward Kim at 303-740-9400 or ekim@eksh.com.
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