Earlier this year, an Internal Revenue Service attorney informed the American Bar Association Section of Taxation that the IRS began a compliance initiative project (CIP) focused on Internal Revenue Code Section 409A.  This CIP is relatively narrow and is expected to only include the 10 most highly compensated individuals at 50 large companies.  The IRS plans to issue Information Documents Requests, commonly referred to IDRs, to these 50 companies.  These IDRs will focus on the initial deferral elections, subsequent changes in deferral elections and the timing of payouts.  Even though this initial CIP is limited in scope, practitioners expect that the IRS will implement a much broader Section 409A enforcement initiative in the not-so-distant future.  Before the IRS begins its examination of deferred compensation arrangements for Section 409A compliance in full force, all compensation arrangements, especially customized deferred compensation plans for highly paid executives, should be carefully reviewed for Section 409A compliance.

Section 409A was added to the Internal Revenue Code in 2004 in response to perceived abuses of deferred compensation arrangements revealed by scandals relating to Enron, WorldCom, and other corporations, several years earlier.  The general purpose of Section 409A is to govern the timing of the payment and taxation of compensation deferred under nonqualified arrangements.  The application of Section 409A has been broadly interpreted and impacts almost every type of compensation arrangement, including employment agreements, severance agreements, equity plans and even incentive bonus plans.

Section 409A essentially imposes three different design and operational requirements.  First, the plan may not permit deferred compensation to be distributed earlier than certain events or specific dates.  Permissible distribution events include the executive’s death, disability and separation from service, and a change in control of the company.  Second, except as otherwise provided, the arrangement may not accelerate (or delay) the payment of the deferred compensation or change the form of such payment (i.e., from lump sum to installment payments).  Finally, a taxpayer electing to defer compensation must generally make such election before compensation is earned and within a certain period of time established by Section 409A and its underlying Treasury Regulations.

If a deferred compensation arrangement fails to comply with these requirements, in either form or operation, then the compensation deferred under such arrangement will be subject to current taxation and an additional tax of 20 percent will be imposed on the deferred amount.  It is important to note that the additional tax, if applicable, will be imposed on the executive and not the corporation operating the plan.  Nonetheless, corporations operating deferred compensation arrangements are incentivized to comply with the requirements of Section 409A because the executives participating in such plans are valuable to the success of its operations.

Throughout the years, the IRS issued several notices, which provide guidance for the correction of certain operational and/or documentation failures of Section 409A.  See Notice 2008-113 (operational failures) and Notice 2010-6 (documentation failures).  If such failures are voluntarily corrected, then the executive may avoid or reduce current income inclusion of the deferred compensation and additional taxes.  However, the types of operational and/or documentation failures that may be corrected under these notices are limited.  Moreover, relief under these notices is not available for an executive if either the executive or the corporation operating the plan is under examination by the IRS, specifically relating to “nonqualified deferred compensation.”  For this purpose, an executive is treated as under examination with respect to nonqualified deferred compensation if that individual’s federal income tax return (i.e., Form 1040) for the taxable year is under examination.  A corporation is treated as under examination with respect to nonqualified deferred compensation if such corporation receives written notification, such as an IDR, from an IRS agent specifically citing nonqualified deferred compensation as an issue under consideration.

The scope of the IRS examination under the new CIP is still unknown.  Therefore, now is the critical time for corporations to review all their compensation plans for Section 409A compliance and, if necessary, take advantage of the available operational and/or documentation correction programs before participation is precluded by an unexpected audit.