Thinking About the Year Ahead in Benefits and Compensation

I was talking to a member of the benefits press the other day and after the formal interview (for an article) was over, the reporter, looking for ideas for 2017 articles, asked for a favor. Paraphrasing, if I were running a Benefits or Compensation, or HR function at a good-sized company, what are some things that I would make sure that I did in 2017 including perhaps some things I had not done in the past?

I thought that was a pretty good topic. It's something I think about from time to time and frankly, I'm hoping that that reporter will think of me in the future when writing on some of those topics.

But, if you are reading this, you might be one of my faithful (or first-time) readers and you probably don't want to wait for those articles. So, I'll give you a little preview with a few of my thoughts.

Be a Better Partner

I know -- that sounds strange for Human Resources. People in HR virtually always think of themselves as good partners for the rest of their organization. But, perhaps surprisingly to our HR heroes, their colleagues might not agree.

To Finance, HR is a cost center. Face it, HR doesn't make money. HR doesn't have a product. HR doesn't sell goods and services. HR costs money. And, because of that, Finance may not think of HR as good partners. So, if you want to be better thought of by Finance, think in terms of dollars and cents. When you find a solution that saves money, make sure your Finance partners know about it and make sure you get some credit for it.

Somewhat similarly, Legal may think of you as a litigation risk. After all, there may be more laws on the books that deal with how an employer treats an employee than any other area. And to Legal, each one of those may represent a risk. Legal would like nothing better than to know that you have sound processes and procedures and probably more importantly that you are following them. It's amazing in reading through employment litigation how often a case falls apart for the employer because they had a set of procedures and they left a few steps out in, for example, terminating an employee.

Oops!

Implementing Those Partnerships

It's great to think about those partnerships, but thinking about them isn't very useful if we don't do something with those thoughts. Let's consider Finance first.

Most every element of your department has a cost associated with it. For 2017, I'm sure you have budgets. But, how about years after 2017? That's a little bit tougher, isn't it? Some of your costs are controllable. You can manage your payroll by the general cost-of-living type increases that you provide. How about your pension commitments? That's a tough one, huh?

First off, your actuary should be on top of that. You should never be getting a pension surprise from year to year or even quarter to quarter. You're not one of those who is getting surprises, are you? If you are, you don't need to be.

I've spoken with benefits people in the past who tell me that's a nice goal, but we just don't have much budget, we really don't have time and we don't have the staff to work with you so that you can get us what might be useful to us.

Suppose I told you that you don't need much budget. This is a very inexpensive project. In fact it's so inexpensive that more often than not, we'll save you more than you spend.

Suppose I told you that we don't need much of your time. In fact, I'm going to round up and say I need 15 minutes of it, but in reality 2 or 3 minutes will probably suffice. Although, to be fair, when I do have results for you, you'll probably want to save an hour or more to go through what we've found for you. After all, what good would discovered savings do you if you didn't actually know how to get them.

And, then there's that staff that you don't have to get us information and answer our questions. Don't worry -- I said that I don't need more than a few minutes of your time. It turns out that I don't need your staff's time either. It's true. All of what I said is true.

Turning now to partnering with Legal, you don't want your department to be thought of as a litigation risk, do you? Well, with respect to each of your plans and programs, you probably have a whole bunch of processes and procedures?

• Are they current? When was the last time they were updated? When was the last time anyone even looked at them?
• Are you following them? Every one of them?
• Do they still make sense? Would you make changes to them not because the law changed since that would necessitate changes, but because they're just not really appropriate in 2017?

I know, this all seems a bit pie in the sky. But, read through your favorite benefits digest tomorrow. There's probably something in there about litigation. What went wrong that caused a lawsuit to have a chance?

• A committee did not use a well-reasoned process in selecting plan investments.
• A committee actually had such a process, but didn't follow it.
• A plan document was vague enough that two reasonable people might interpret it differently. Counsel is telling you that you will win because of this notion sometimes known as "Firestone deference" (essentially, the administrator of a plan should have broad latitude in its administration), but even if you win, litigation may be costly and eat up a lot of your resources.
• You had a low performing individual in the company whose supervisor doesn't like documenting performance reviews, so when that individual was terminated, there was no written basis on which to do it.

I could go on, but you get the gist. But looking at all those things is tedious and you just don't have the staff to do it, but there is a solution.

Happy New Year. Have a great 2017.

409A Audit Could Be Coming to Your Company

All the way back in 2004, Congress passed and President George W. Bush signed into law the American Jobs Creation Act (Jobs Act). While it does not appear to have created many jobs, the Jobs Act added Section 409A to the Internal Revenue Code. The reasons were twofold -- first, to ensure that participants in nonqualified deferred compensation plans (NQDC) would never be advantaged over those in qualified plans; and second, to raise revenue for the federal government.

Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.

Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.

Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:

• Nonqualified defined benefit pension plans that do not have the same formula as a broad-based DB plan in which the covered executives also participate;
• Other nonqualified DB plans that simply make up for IRS limits (415 and 401(a)(17));
• Deferred compensation plans that look different from the company's 401(k) plans; and
• 401(k) mirror plans.

In other words, the target seems to be executive retirement plans.

What can you do?

To understand what the solutions might be, your first need to understand the problems. Generally, there are two ways that you can violate 409A -- either by failing to have or failing to have an appropriate written plan document, or by failing to follow both the plan document and the law and regulations.

In either case, the penalties are severe. But, those penalties are not imposed on the company. Instead, they are imposed on the executive, even if he had neither influence on nor knowledge of the defect from which that penalty will arise.

How bad is the penalty? It's this bad:

• An additional 20% income surtax on the amounts deferred and not compliant for all taxable years in which that was the case; plus
• Interest on previously unpaid taxes (due to failure to include the deferred amounts in income in the year in which they were deferred) at the Federal Underpayment Rate plus 1%.

And, that's in addition to ordinary income (and other) taxes that would be owed on those amounts. They add up quickly.

For most 409A defects, however, there are correction methods, structured somewhat analogously to those under the EPCRS program for qualified plans.

Many of you will seek help from counsel and from tax advisers. That may be a good solution for you. A problem that can occur in either case, though, is that it's very possible that neither has significant experience with determination of 409A benefits or with the administration of those benefits.If they do, that's great. But, if they don't, you probably need to look for additional expertise.

Are You Handling Your FICA Taxes on Deferred Compensation Properly?

FICA taxes on nonqualified deferred compensation (NQDC) were never a big deal. Chances were that if you had NQDC that your pay was well over the Social Security Wage Base. So, while there were situations where that was not the case, the IRS largely ignored the issue. There just weren't enough situations where it applied and there wasn't enough tax revenue in it to worry about enforcement.

Then came the uncapping of Medicare wages. That is, employees and employers were required to pay HI (Medicare) taxes on all wages, not just those up to the wage base. Suddenly, large amounts of NQDC were subject to this tax and it mattered.

For the last few years, there was a court case in Michigan related to payment of FICA taxes. I had largely forgotten about Davidson v. Henkel, but another blog reminded me of it (thanks Mike Melbinger). In the case, Henkel failed to pay FICA taxes on behalf of Plaintiff Davidson and others in the class leaving that class with a significant (to them) tax liability including penalties.

Why do we care? Why am I taking the time to write about this?

Most NQDC plans are drafted by or reviewed by attorneys (as they should be). While this is not always the case, in the typical situations, the plans are somewhat boilerplate in nature. In my personal experience, counsel often does not ask the client all of the details about how the plan will actually be administered. Frankly, even when they do ask, the client may not know. After all, the client may not be administering the plan on its own.

The plan document is a legal document. When that document says that the company shall remit FICA tax, it must. When the document instructs how or when FICA taxes will be calculated, that is what must happen.

In many plans, this is really a non-issue. There may only be one way to calculate these amounts and taxes will be due annually. In defined benefit (DB) SERPs and Restoration Plans however, there are multiple ways of handling the FICA situation. Most prominently, the sponsor may calculate (and remit) FICA taxes when they are reasonably ascertainable (a technical term from the regulations, but for many, this means at the employee's date of termination from the company) or by early inclusion which essentially means that FICA is calculated and paid annually. Early inclusion is sometimes more beneficial than waiting until retirement, but it is also more administratively complex.

Some plan documents leave the option of payment entirely to the discretion of the sponsor or administrator. Others specify that there will or will not be early inclusion.

What does yours say? Do you know?

Suppose your plan specifies early inclusion and you've not been doing that, do you have a problem? You might.

In fact, in my experience, more companies than not are not particularly on top of the administration of their NQDC plans. They've never particularly focused on compliance with these FICA rules or, even worse, Code Section 409A.

Oftentimes, it will be a good investment to have someone assist you in making sure the processes in this regard are being handled properly.

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.

IRS Still Auditing Executive Compensation

Over a year ago, the IRS announced that it was stepping up its audit program with respect to executive compensation. Frankly, any activity at all would have been a step up. For the majority of the time since we have had an income tax (and therefore an Internal Revenue Code) in the US, audits of executive compensation have been virtually nonexistent. Why? The biggest reason is that there have not been a whole lot of rules. Number two on the list is that the IRS has not chosen to place its resources there.

For many who are fortunate enough to be the beneficiaries of executive [levels] of compensation, the good news is that most are still not getting audited. However, with the interplay of Code Sections 83 (constructive receipt and the economic benefit doctrine plus some other related stuff), 162(m) (the million dollar pay cap), 409A (taxing people to death when they mess up their deferred compensation programs), and 3121(v) (FICA tax on deferred compensation), the IRS has plenty of things to audit. Surprisingly, at least to this writer, we're finding that they are catching people on some fairly tricky applications of the law.

Notably, I've seen or heard of multiple people getting dinged on these infractions:

• Stock awards that vest at a retirement date, causing constructive receipt under Section 83
• Linked retirement plans where the offset from the qualified plan is not well enough specified, causing a 409A violation
• Failure to pay FICA tax on deferred compensation that employers didn't realize technically was deferred compensation
• Improperly constructed performance pay plans that run afoul of 162(m) by not qualifying as performance pay
• Severance pay plans that did not have a 6-month payment delay for specified employees because they looked like broad-based plans. The fact that the compensation considered exceeded the pay cap (401(a)(17)) caused the problem.
• A 409A plan having a plan document that specifies for one set of administrative procedures, but the plan being administered the way it always was before someone wrote a document without bothering to check to see how it was being administered.

There are more, plenty more. There are a few ways that you can handle this.

• Do nothing and play audit roulette.
• Have your documents reviewed by someone other than the person who wrote them (the person who wrote them will read what they intended even if nobody else reads it that way).
• Have your administrative processes reviewed by someone who is not your administrator, but has experience with the administration of nonqualified deferred compensation plans.
• If you find problems, take corrective action. The IRS has been nice enough to give us corrective methods that lessen or eliminate the additional tax burden, but only if you fix them before the IRS catches you.

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.