Targeted IRS examinations of nonqualified deferred compensation arrangements for compliance with Code section 409A have been anticipated for years. Until recently, section 409A audit activity has occurred as part of an examination of an employer's tax return. However, the IRS has commenced specific section 409A examinations of select large employers. The results of these audits will be used to refine and further target future IRS enforcement activity under section 409A. What we are seeing is the first phase of an ongoing 409A enforcement initiative.

In light of this development, employers should review their section 409A compliance and take action to correct errors to the extent possible in advance of an IRS examination. 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):

  • Notice 2008-113 (operational errors)
  • Notice 2010- 6 (documentary errors)

Prior IRS audit activity has focused on key section 409A problem areas, such as:

  • Impermissible payment triggers (e.g., signing of a release of claims)
  • Six-month delay and identifying "specified employees"
  • Faulty reliance on short-term deferral exception
  • Bad "good reason" definition
  • Lack of 409A "savings clause"
  • Accelerated vesting of equity and cash awards on "retirement"
  • Application of the 409A "substitution rule" (particularly in severance situations)

An IRS examination typically begins with an Information Document Request ("IDR") that lists documents that the employer must produce for the IRS to review as well as questions that the employer must answer. Under new procedures, the IRS generally interviews the taxpayer before issuing an IDR in order to gain more insight into the issues the IRS plans to focus on during the examination.  As outlined in the attached presentation, we strongly advise employers to consider outside representation to meet with the IRS in appropriate situations to provide the employer with an experienced advocate and critical insulation.

There are limitations on the documentation that an employer is required to provide to the IRS, so an employer should carefully consider the scope of an IDR before responding. In addition, employers should be cautious in answering the questions set out in IDRs. Section 409A IDRs have been extremely detailed, effectively requiring the employer to take specific legal positions on section 409A compliance to respond. In most cases the examination will involve interviews of employees involved in section 409A compliance. These interviews should be approached strategically. Careful preparation of the witnesses based on experience with IRS interview procedures and content can be extremely beneficial.

Please click here to see the attached presentation regarding how to handle an upcoming IRS examination of an employee benefit plan.

We have long recommended that employers undertake section 409A self-audits periodically to ensure compliance and to minimize exposure from an IRS examination. However, self-audits are now more important than ever. For more information about how to conduct a 409A self-audit or how to approach an IRS examination of section 409A or other issues, please contact the authors of this Legal Alert or your existing firm contact.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.