IRS Initiates Audits Under Section 409A: Now Is a Good Time for Closely Held Businesses to Review Potential Issues
The Internal Revenue Service (IRS) has announced that it will be conducting a focused audit initiative aimed at determining compliance with Internal Revenue Code section 409A. Once it has reviewed the results of the initiative, the IRS will determine what, if any, additional steps will be required to improve compliance in this area. Now that the IRS audits are underway, it is a good time for companies providing deferred bonuses, incentive compensation, supplemental executive retirement plans, stock options, stock appreciation rights, phantom stock, and executive severance payments to review these plans for compliance with section 409A. Specifically, we have seen recurring issues under section 409A in plans of closely held businesses that warrant highlighting for our readers in light of IRS enforcement.
Section 409A imposes restrictions on the deferral of compensation by employees, directors, and other independent contractors (collectively, “employees”). It was enacted as a response to the Enron bankruptcy (the executives were able to receive millions of dollars in payouts shortly before the bankruptcy filing) to limit the control that employees, who are U.S. taxpayers, have over the timing of the recognition of income from deferred compensation arrangements in which they participate.
Deferred compensation under section 409A is defined very broadly and potentially includes any arrangement under which an employee has a right to receive compensation earned in one tax year and paid in a subsequent tax year. This can include, but is not limited to, retirement plans, bonus plans, incentive compensation plans, severance arrangements, stock option plans, stock appreciation rights, phantom equity plans, and individual employment agreements.
Generally, deferred compensation is taxed under section 409A when it is no longer subject to a substantial risk of forfeiture as defined in the final regulations. Further, to meet the rules of section 409A, a plan must provide that distributions from the deferred compensation plan are only allowed on separation from service, death, a specified time (or under a fixed schedule), change in control of a corporation, occurrence of an unforeseeable emergency, or if the participant becomes disabled. The plan may not allow for the acceleration of benefits, except as provided by regulation, and if the employee is electing to defer some of his current salary, the deferral must be made no later than the close of the preceding tax year, or at such other time as provided in the final regulations. Compliance with section 409A is critical because the full impact of a failure to comply is felt by the employee (typically an executive or other key employee) who will have to pay current income taxes on the deferred amounts along with a 20% excise tax and interest if the deferred compensation is taxable in a prior year as a result of the failure to comply.
Areas of Concern for Closely Held Businesses
Plan Documents – The first consideration is that you need a section 409A-compliant plan document if you are providing any plan or program that defers compensation from one tax year into a future tax year. Closely held businesses appear to run into the most issues in this area as it relates to bonus programs, long-term incentive plans, supplemental executive retirement payments/plans, and executive severance payments. An employment agreement can serve as the plan document, but it must contain the necessary language and/or be designed to comply with section 409A. Failure to have a compliant plan document subjects the deferred income to income tax, interest, and the 20% penalty tax at the time the benefit vests or is no longer subject to a substantial risk of forfeiture, if later.
Employment Agreements – When reviewing employment agreements, we have frequently seen provisions for deferred bonus payments, incentive payments, option grants (usually stock), retirement payments, and severance payments that do not comply with section 409A. (In the not-for-profit area, we frequently see provisions for supplemental retirement payments and/or contributions that do not comply with sections 457 or 409A. Please refer to our article of January 2013 ‘Beware of Section 409A Traps in Employment Agreements.’
Stock Option and Stock Appreciation Rights (SAR) Plans – Generally, stock option and SAR plans are exempt from section 409A. However, for non-public companies there are specific requirements that must be met in order for the plan to be exempt from section 409A. The most frequent issue that we see is the failure to issue the right at the fair market value of the company’s stock as of the date of grant. The regulations under section 409A contain extensive rules regarding the valuation of closely held and start-up companies with no public market for their securities. The rules also contain safe-harbor valuation methods that put the burden of proof on the IRS to rebut the valuation, if audited. Generally, the company should consider having an independent valuation performed to determine the fair market value of the stock. If a company issues stock options or SARs at below fair market value, they are subject to the plan document, deferral election, payment restrictions, and timing and form of distribution requirements of section 409A. These requirements eliminate the flexibility and benefit of providing stock options and SARs. Failure to comply will also subject the income on exercise to the 20% penalty tax under section 409A.
Phantom Stock Awards – Many times we see phantom stock (or similar grants for other types of entities such as partnerships and LLCs) grants to key employees. Phantom stock provides a bonus based on the value of a stated number of shares of company stock. Like SARs, phantom stock is typically subject to vesting based on performance targets or elapsed time. Unlike SARs, which may be structured to avoid falling under the parameters of section 409A, phantom stock is deferred compensation, subject to section 409A. The regulations under section 409A include rules requiring that the plan document specify the time of payment at the time of the grant of the award and also provide prohibitions against the acceleration of vesting and payouts except under limited circumstances. While more complex plan designs are possible to comply with section 409A, , most phantom stock plans are designed to avoid section 409A restrictions by making the award payable immediately upon vesting, thus meeting the short-term deferral rule (generally payment within 2 ½ months after the end of the tax year in which vesting occurred). To comply with the short-term deferral rule under section 409A, it is advisable that the intent to settle the award within 2 ½ months after the tax year of vesting be stated in the plan document.
Discretion of Board or Executive Officer over Payments – We have seen several instances of deferred compensation plan documents for executives or key employees that grant the board of directors or the chief executive officer discretion over the timing and/or form of payment to be made to other executives upon vesting of their benefit. The regulations under section 409A prohibit this form of discretion as they require the plan document to specify the timing and form of payment under the plan. If the plan document allows for discretion, the payments to the executive will be subject to the 20% penalty tax.
Plans that do not comply with section 409A may be able to correct errors under IRS correction programs. There are two formal IRS correction programs for Section 409A errors, which cover a range of errors and offer reduced/eliminated penalties for sponsor self-corrections (but that require action before an audit is commenced):
- IRS Notice 2008-113 established a correction program with regard to “operational” failures to comply with section 409A. An operational error occurs, for example, if a payment is accelerated into an earlier year than permitted by the plan document.
- Notice 2010-6 and Notice 2010-80 established a section 409A correction program that permits a plan sponsor to correct many types of “document” failures. A document failure generally relates to a provision in a deferred compensation arrangement that does not satisfy the Section 409A requirements.
Section 409A contains many potentially expensive pitfalls for companies unaware of the breadth of its reach and its hash penalties on employees. With the IRS now actively auditing for compliance in this area, it is imperative that companies review their plans and employment agreements for compliance with section 409A in both form and operation.