Wednesday, November 17, 2010

Would Your Deferred Compensation Plans Survive an IRS Audit?

Since 2005, US nonqualified deferred compensation (NQDC) plans have been subject to the horribly onerous and confiscatory Code Section 409A. Employers and participants, could your plan(s) survive an IRS audit?

In short, NQDC plans that are not in compliance are potentially subject to this treatment:

  • Inclusion in income
  • Additional 20% federal income tax 
  • Interest as if the amounts had not been deferred at the Federal Underpayment Rate plus 1%
Bad stuff, huh? Unlike virtually everything else in the Tax Code, to the extent that there is a failure to comply (whether it is the fault of the employer or employee), the employee pays these taxes. 

How do you have a failure to comply (not an exhaustive list)?

  • Plan must be in writing.
  • Written plan must be compliant with 409A.
  • Each participant must make a bona fide initial deferral election
    • Generally before deferring, they must specify in writing when and in what form they will take their distribution.
    • Changes to the initial deferral election require a 5-year pushback, and must be made at least one year before the scheduled distribution.
  • Plan must be operated in compliance with the written document
  • Plan must be operated in compliance with 409A
So, do you know if your plan(s) comply? How would you feel if your plans were audited by the IRS? As part of a current initiative, the IRS is auditing a large number of NQDC plans. The good news is that if you have errors, but you catch them and correct them before the IRS catches them, you may be able to reduce or in some cases totally avoid these 409A penalties. And, for the requirement to have a written plan that is 409A compliant, generally you have until the end of 2010 to fix documentary errors. 

Guidance on the correction programs can be found in Notice 2010-6 to correct documentary failures and Notice 2008-113 to correct operational errors .

These notices are long and complex. Many organizations have found that they don't have the expertise to follow this process in-house. Do you need help?

Nothing in this post is to be construed as legal, tax, or accounting advice. These can only be obtained from qualified counsel.

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