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Next Up from the IRS: Introducing the Section 409A Compliance Initiative Project

This article originally ran on July 11, 2014.

By Linda Segal Blinn, J.D.

While summer brings thoughts of vacation plans, the IRS reportedly is using this time to roll out a new compliance initiative project focusing on whether non-qualified deferred compensation arrangements are operating in accordance with Internal Revenue Code (Code) Section 409A. 

An IRS official who spoke unofficially at the May Employee Benefits session of the American Bar Association Section of Taxation indicated that the project will focus on a limited number of large companies at the outset (approximately 50 corporate taxpayers), and will assess taxpayer compliance with Code requirements governing non-qualified arrangements. 

Code Section 409A determines when participant deferral into certain types of plans including an ineligible Code Section 457(f) plan, grandfathered deferred compensation plan that predate Section 457(b), or other non-qualified plan  or arrangement (other than a 415(m) governmental excess benefit plan) is subject to federal income tax. Failure to comply with Section 409A will cause amounts to be included in an individual’s gross income in the tax year in which the amount was not subject to a substantial risk of forfeiture; in addition, interest and an IRS 20% excise tax also apply to the amount required to be included in that individual’s gross income.

According to the IRS official, the group subject to this IRS compliance initiative project was culled from an existing population of employment tax audits. The IRS will limit the scope of review of such employers to the top 10 highly-paid employees and review only the years under exam. The IRS currently anticipates that the project will be completed within the next 12 months.

The focus of the Section 409A compliance initiative project, operated through the IRS’ Small Business/Self-Employed Division, will be upon:

1. Initial deferral elections. In the first year of eligibility to participate in a plan, an individual may make an initial election to defer within 30 days of eligibility. Special rules apply to an initial election of performance-based compensation — such an election must be made no later than six months before the end of the performance period.

2. Subsequent deferral elections. Subsequent deferral elections must be made no later than the close of the prior taxable year. The deferral election is irrevocable for the applicable tax year.

3. Payouts in accordance with Section 409A. Section 409A requires that either a participant specify the time and form of distribution at the time of initial deferral election or that the plan provide the time and form of payments when a participant has a distributable event. Permissible distributable events under Section 409A are the participant’s separating from service, dying, becoming disabled, or reaching a time or fixed schedule under the plan, or a change in the ownership or control of employer. 

IRS rules permit a participant to change an election with respect to either the timing or the form of distribution only if the new election generally is not effective until at least 12 months after the election was made. Unless otherwise permitted under IRS guidance, a change cannot provide for acceleration in the timing or form of benefit.

The compliance initiative project will also focus on taxpayer compliance with the six-month delay requirement for payments made to specified employees in connection with their separation from service.   

An employer subject to this compliance initiative project will receive an IRS information document request. As of the time of publication, the information document request used for the Section 409A compliance initiative project was not publicly available. 

While the scope of the compliance initiative project is not extensive, an employer with a non-qualified plan or arrangement should consider assessing whether its current procedures are appropriate and have sufficient internal controls. The IRS has indicated that the compliance initiative project is a means of determining whether current audit techniques and information document requests are effective in obtaining information about compliance with Section 409A.

Linda Segal Blinn, J.D.*, is vice president of Technical Services for Tax-Exempt Markets at Voya Financial. *Note: Author is not a practicing attorney.