U.S. Internal Revenue Service Announces Deferred Compensation Audit Initiative

The Internal Revenue Service (IRS) recently announced that it has started a formal audit initiative to evaluate compliance with the rules for nonqualified deferred compensation under Section 409A of the U.S. Internal Revenue Code (Code). Section 409A of the Code imposes specific requirements on the timing of deferral elections and the designation of the time and form of payment of amounts under nonqualified deferred compensation plans. Severe tax penalties are imposed on the employee if the requirements are not satisfied. Under the first phase of the initiative, the IRS will audit up to 50 large companies selected from a group of employers previously identified for an employment tax audit. Following the first phase of the initiative, the IRS will determine its next steps.

The limited-scope audit will focus on compliance in three key areas: (i) initial deferral elections; (ii) subsequent deferral elections; and (iii) distributions in accordance with one of the permitted payment events, including the requirement that certain distributions to "specified employees" of public companies be delayed for six months. As part of the audit, the IRS is likely to review plan documents, election forms, and evidence of payments to ensure compliance with Section 409A of the Code.

In light of the IRS audit initiative, companies should take the opportunity to self-audit their deferred compensation plans for documentary and operational compliance with Section 409A of the Code. The IRS has correction programs under which many operational or documentary issues can be corrected prior to audit. It is important to note that once the company or the employee is under IRS audit on these issues, the correction programs may no longer be available.