Beware the Compensation Audit

OK, HR people, if your company got audited, how would it do? I'm not talking about the audits of broad-based employee benefit plans that the IRS and DOL have been conducting for years. I've heard attorneys give advice with regard to those benefit plans that they may not be compliant, but you'll never get caught on audit. I'm talking about compensation audits, targeting primarily executives. I'm talking about 409A and 162(m) audits. Would you feel confident if you got that dreaded letter than an auditor would be arriving soon? Many companies have felt confident. Many of them have not been so happy when the auditor left.

Before discussing those audits and what you might do to prepare (long before you get that audit notice), I digress. What is your role in the company? Do you have a boss? Murphy's Law says that the first person in the company with a 409A problem will be either your boss or your boss's boss. In my experience, the 409A version of Murphy's Law strikes far more often than logic or probability dictate that it should. And, if it does, you are going to get blamed ... and that's not good.

Let's suppose you do get a request for information from the IRS for a 409A audit. They give such requests a nice name. They call them Information Document Requests. I have one sitting in front of me. Thankfully, from my standpoint, it was provided to me by a company that I did not assist with their 409A compliance process. I say thankfully because at the end of their audit, they were not happy with what the IRS found. In any event, here is what the IRS requested (paraphrasing somewhat to take out IRS-speak where possible) from them:

• Every plan and arrangement providing for a legally binding right to compensation in one year, but payment in some future year that is not subject to 409A. The company is then asked to explain why it is not subject to 409A. If the answer that they will give is the exclusion for short-term deferrals, then the company is to provide the relevant terms of that plan and and relevant terms for substantial risk of forfeiture.
• Terms and conditions, including deadlines for initial deferral elections.
• Terms and conditions for any subsequent deferral elections, including documentation of the initial deferral election, documentation to show that the subsequent election was made at least 12 months before the initial payment date and documentation to show that the subsequent election reflects at least a five-year pushback. 
• Detail related to any accelerations in payment that have been made.
• A list of specified employees and the times at which such employees have been specified employees.
• Payments made to specified employees and documentation demonstrating compliance with the six-month delay rule.
• Any funding of deferred compensation as a result of an event relating to a decline in the company's finances.
• Violations of 409A and whether they were fixed in one of the IRS 409A corrections programs.

For some companies, that's a lot of stuff (that's a technical term for saying that it may take you a long time to comply with the Information Document Request). But, that's only the first part of the misery. Let's look at where the IRS has been generating revenue (that is also a technical term, this time for finding compliance errors).

• Time and form of payments
• Short-term deferral rule
• Identifying specified employees

With regard to time and form of payments, the biggest culprit has probably been in severance plans. Recall that broad-based severance plans may be exempt from 409A, but to the extent that the payment is more than two times the pay cap under Code Section 401(a)(17), they are not. So, we are talking about executive severance payments here and there have been a lot of them the last few years. 

How have companies gone wrong? Many executives have had employment agreements that provide for significant severance payments in the event of termination without cause. And, in a lot of those cases, they allowed the executive freedom to take that payout in a lump sum or installments as he saw fit. 

Oops! That's a 409A violation. And, if he was a specified employee and he took the payment within 6 months of separation from service, Oops again.

Companies (and their advisers) have taken significant advantage of the short-term deferral rule. Oversimplifying somewhat, here's how it works. Suppose compensation is earned in one year (and vests in that year) and is paid out (without employee choice) by March 15 of the following year, then it usually qualifies as a short-term deferral. Think of a typical annual bonus plan.

Now, let's change the situation. An employee earns compensation (and it vests) in one year. He separates from service the next year before March 15 and the amount gets paid out (because of the separation from service). It is NOT a short-term deferral because the payment could have been after March 15 if the separation from service had occurred later. Essentially, you can't dodge the short-term deferral rule in this fashion.

Identification of specified employees is not easy for large companies. At a minimum, they are the key employee group as determined under Code Section 416(i). Here is the problem. During the year, you may not know who those 50 highest-paid officers are for a year. This is why the 409A regulations defined specified employees as compared to just key employees. Specified employees can be a group of up to 200 that includes the key employees, but may also include certain other employees. It's that group that must not be paid out within 6 months of separation from service. And, all 409A plans and arrangements of an employer must use the same definition of specified employees.

Many companies have applied the 6 month delay rule to all 409A plans of the company for all employees. In that case, it doesn't matter who the specified employees are. Other companies have chosen not to do this. Therefore, they need to know who their specified employees are. IRS experience says that many companies don't know who their specified employees are. This is another good revenue source for them.

So, how should companies prepare for the possibility that they may get audited? Have an independent third party review. Don't have it done by the people who did your initial compliance work. They'll never think they made any mistakes. If the initial work was done by an attorney, consider having the third party review done by a consultant. You'll get a different and hopefully useful perspective. If the initial work was done by a consultant, consider an attorney to do the third party review.

Or, in either case, if I didn't do the initial compliance work, I'll give you a different perspective than the person who did it originally.