Do the New IRS Nonqualified Plan Audit Guidelines Mean Section 409A Audits are Coming?

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Foley & Lardner LLPThe IRS updated its Nonqualified Deferred Compensation Audit Techniques Guide (the “2021 Guide”) in June 2021. The 2021 Guide replaces a similar guide that was published in June 2015.

The 2021 Guide does not shed new light on the standing or treatment of nonqualified plans under the Internal Revenue Code (“Code”) or resolve any open issues under Section 409A of the Code (“Section 409A”). Rather, the 2021 Guide is a user-friendly document – drafted to highlight some issues that are the foundation of nonqualified deferred compensation plans and clearly intended to be used as a reference to assist IRS auditors as they audit nonqualified deferred compensation plans. Below, we discuss some questions that our clients have asked in connection with the publication of the 2021 Guide.

What is a nonqualified deferred compensation plan?

At a very high level, and consistent with the description in the 2021 Guide, a nonqualified deferred compensation plan is an elective or non-elective plan, agreement, method, or arrangement between an employer and an employee (or service recipient and service provider) to pay the employee compensation in the future, other than pursuant to a qualified plan or certain other specified plans. Nonqualified deferred compensation plans are subject to Section 409A unless a specific exemption is met.

The 2021 Guide does a good job of reminding us that a nonqualified deferred compensation plan can come in many forms including:

  • Salary Reduction and/or Bonus Deferral Arrangements – Agreements that defer the receipt of otherwise currently includible compensation – salary or bonuses – by allowing the employee to defer receipt of a portion of his or her compensation to a later year in a manner that is not otherwise permitted by other sections of the Code (e.g., Section 401(k) governing employee deferrals to qualified retirement plans). This can take many different forms, including a certain provision in an employment agreement, an individual arrangement, or larger arrangements.

    Note: As the 2021 Guide reminds us, phantom stock plans are nonqualified deferred compensation arrangements, not stock arrangements. Therefore, depending on their terms and conditions, they may be subject to Section 409A. 

  • Excess Benefit Plans – Nonqualified deferred compensation plans that provide benefits only to employees whose benefits under the employer’s qualified plan (e.g., 401k plan) are limited by the annual additions limit under Code Section 415.
  • Top-Hat Plans (sometimes known as Supplemental Executive Retirement Plans/SERPs) – Nonqualified deferred compensation plans maintained primarily for a select group of management or highly-compensated employees. These plans usually complement the offerings under a qualified defined contribution or defined benefit plan. They are similar to an Excess Benefit Plan, but generally provide additional benefits.

Does this mean that audits are coming?

We do not know.

What we do know is that (i) audit activity in this area has declined in recent years, but that the IRS has requested substantial budget increases, (ii) Congress may be inclined to encourage more enforcement in this area to help fund certain other government initiatives, and (iii) with this new 2021 Guide, the IRS is prepared to audit more nonqualified deferred compensation plans.

What should we do now?

Take stock of your existing and future nonqualified deferred compensation arrangements. 

Depending on how deep a dive you are willing to take, this could include reviewing some or all of the following:

  • Do you know what nonqualified deferred compensation arrangements you maintain? As the IRS reminds us (and their auditors) in the 2021 Guide, some are nothing more than a few provisions in an employment contract.
  • Do you know whether each nonqualified deferred compensation arrangement – including bonus plans and phantom stock arrangements – is intended to be exempt from or compliant with Section 409A? In our experience, the most often used exemption is the “short-term deferral” rule.
  • For any nonqualified deferred compensation arrangements subject to Section 409A, review the “top five” questions below:
    1. Have you reviewed operational compliance of initial and subsequent deferral elections?
    2. Have you confirmed that deferred amounts are taken into account for FICA tax purposes at the later of when the services are performed or when they become vested?
    3. Does the timing of the employer’s deduction match the employee’s inclusion of the compensation in income?
    4. Have you confirmed that payments have only been made in connection with Section 409A permissible payment events (e.g., separation from service or change in control), and that no amount has been impermissibly accelerated or delayed?
    5. Have you confirmed that the funding arrangements, if any, comply with Code Section 409A(b)?
  • Conduct additional due diligence in accordance with the “Examination Techniques” in the 2021 Guide.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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