Normally when the IRS contacts you, it's not good news. But for New Jersey-based employee benefits consultant Dominick Pizzano, hearing from the IRS was one of the high points of last year.
The story begins in April 2009, when Milliman published Dominick's white paper entitled "Can nonqualified deferred compensation plans brave our new world?" (available at www.milliman.com/ndcp). The paper reviewed the history of nonqualified deferred compensation plans (NDCPs): how they were created as a legitimate tool for attracting and rewarding key employees. However, the Enron debacle showed that unscrupulous executives could use an NDCP to grab a failing company’s assets before shareholders and rank-and-file employees even realized there was a problem. More recently, the failure of risk-management processes at major financial institutions has put a spotlight on all forms of executive compensation. As a result, the IRS created new rules governing NDCPs that are known as Section 409A.
The audits are coming—for individuals and organizations
Describing these new rules as "sprawling" and "onerous," Dominick's white paper noted that the IRS is preparing an aggressive audit campaign: "The IRS now has the authority, the support of the public and politicians, and mountains of motive to aggressively pursue NDCPs that violate tax code section 409A." Dominick adds that these audits, "could bring in additional tax revenues via imposition of the hefty 409A penalties for noncompliance."
Although it is the NDCP plans themselves that may be noncompliant, the penalties have the greatest impact on individual plan beneficiaries. If the IRS discovers a violation, money that was previously deferred becomes taxable and is treated as a late payment. Interest penalties are assessed, plus a 20% excise tax. Thus, there's a major incentive to comply.
In practice, Section 409A compliance has proven to be so difficult that the IRS has implemented two separate "self-correction" programs, which can provide partial or full relief for plan sponsors who rectify eligible errors before they or the individual participants are audited. Fortunately, the IRS realized that the extreme complexity of the 409A rules could very well lead to many unintentional errors—whether through mistakes in plan operation or improper plan documentation.
Milliman to the rescue
That also explains why Dominick received a message, last November, from the IRS; it was a request to use the "brave new world" paper as a training tool. From Dominick's perspective, this was the ultimate endorsement and, of course, Milliman was happy to grant the request.
The paper methodically addresses the key issues plan sponsors (and IRS agents) need to understand about Section 409A, delving into the many intricacies. But there are big-picture issues involved as well. Because Section 409A is so broad in scope, it covers almost any conceivable type of compensation arrangement—including informal ones. As a result, organizations may not realize that they have a "plan" that is subject to the new rules. For example, a company's HR department may not realize that the CFO or in-house counsel has set up special arrangements for upper-echelon executives. Another compliance pitfall stems from the perception that the IRS is only targeting corporations. In fact, the audits are impacting all types of organizations, including colleges, hospitals, and not-forprofit entities. As Dominick puts it, "No one is really immune from the possibility of an NDCP audit."
An urgent need to review—and correct
What can organizations do to prepare themselves? First, it’s essential to act quickly. The initial need for speed is because relief is conditioned on fixing problems in plan documents and operations before they are audited. In addition, the document relief program provides complete relief for certain errors corrected before December 31, 2010. And, on the plan operations side, it’s important to try to fix any problems in the same tax year. Because NDCPs are designed to defer taxes, the operation correction program is more forgiving of problems that are corrected before tax ramifications arise.
Dominick also recommends that organizations pull together a multidepartmental team that includes everyone in a position to know about existing compensation programs. The team should prepare an inventory and then call in an experienced firm to review all of the documentation and operations for Section 409A compliance. Says Dominick, "We're helping our clients identify trouble areas and suggesting ways to fix them. It's quick and efficient and, most important, it provides our clients with the peace of mind that they will be 409A-OK—if the IRS happens to call."