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IRS Announces New Audit Initiative: Compliance Review Strongly Recommended to Avoid Severe Adverse Tax Consequences

July 9, 2014

The Internal Revenue Service (IRS) recently announced that it will begin conducting focused audits aimed at determining compliance with Internal Revenue Code Section 409A.   Section 409A is a complex and easily overlooked provision of the tax law which can result in draconian penalties.  For this reason, we strongly recommend that our clients become familiar with the law, and review their existing documents now to avoid these penalties. 

Section 409A of the tax law was designed to prevent companies from accelerating or changing the time and form of payment.  The law’s unintended consequence is that seemingly innocent or commonplace transactions (such as deferred compensation in employment agreements, severance payments or payments over time in an Asset Purchase Agreement) can run afoul of Section 409A.  Violations impose extremely harsh consequences on employees rather than employers, which can be avoided by timely corrections or informed planning.

In particular the IRS will be looking at three areas of concern: 

  • initial deferral elections
  • subsequent elections to re-defer previously deferred amounts and
  • distributions to employees 

Now that audits are beginning to take place, businesses that utilize the following types of compensation tools should ensure that they are Section 409A compliant:

  • Severance plans or agreements
  • Traditional deferred compensation payments
  • Deferred bonuses
  • Incentive compensation (such as LTIP or STIP)
  • Supplemental executive retirement plans
  • Stock appreciation rights and
  • Phantom stock

The failure to comply with Section 409A can result in the acceleration of all income taxes to employees on the full amount deferred, an additional 20% tax, plus interest at the highest underpayment of tax rate plus 1%.  That is, the employer’s failure to comply with Section 409A can create a large tax liability “today” for existing employees and/or former employees who have not yet received payment of the amounts which are now being taxed.  The inadvertent creation of this tax exposure is a breeding ground for employment disputes from current or former employees who relied on their employer to “pay them properly.”

With these considerations in mind, we recommend reviewing all benefit plan documents, employment agreements, stock option or stock appreciation rights plans, phantom stock awards, Asset Purchase Agreements and materials evidencing the Board of Directors or Officers discretion over payments.  In addition, advice should be sought where an acquisition is contemplated or when severance payments are being offered or made to departing or former employees. 

We are experienced with IRS correction programs which may be available to correct discovered errors.  There are presently two formal programs which may offer reduced (or eliminate) penalties for those employers who self-correct prior to the commencement of an audit.  Getting ahead of this problem, if one exists, is likely a better solution than having to confront the matter in an audit.

For more information on the new IRS Section 409A audit initiative, please contact Stephen Ferszt or your attorney.

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