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January 07, 2010 |
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IRS Allows Fix On Deferred Compensation Tax |
(Dow Jones) Compensation plans that set a future date to dole out bonuses and other
pay are coming under the microscope at the Internal Revenue Service,
but the agency has just offered a chance to fix costly errors related
to these plans as it gears up to conduct audits.
Deferred compensation plans are often associated with
highly-paid executives but not limited to them. They are ruled by an
especially tricky section of the tax code, and errors setting them up
can trigger steep IRS penalties.
The provision that governs these plans, known as Section
409A, went into full swing last year and the tax authority apparently
wants to make sure employers are obeying it. Yet there is still a lot
of confusion on the part of companies and their tax advisers over how
to comply.
On Tuesday, the IRS came out with guidance on following the
rules, and said it would give limited opportunities to correct certain
kinds of errors, potentially sparing some people heavy tax penalties.
The guidance was long awaited and will be a big help, especially to
those who ran afoul of the complicated rules unwittingly, according to
Daniel L. Hogans, a former Treasury tax policy attorney and one of the
drafters of the original Section 409A regulations.
Specifically, it lets companies tweak the actual documents
that spell out deferred compensation arrangements. A common place to
find errors is in severance agreements tied to retirement or a
negotiated termination of employment, but they crop up in many kinds of
arrangements.
Compensation plans in question are nonqualified and "can
apply to anybody," said Elizabeth Drigotas, a principal in the
Washington, D.C. office of Deloitte Tax LLP. Examples, she said, might
be a "broad-based three-year bonus plan, or stock options." Plain
vanilla long-term plans where an employee elects each year to defer pay
are also part of the mix, but qualified plans such as 401(k)s or
457(b)s are not.
"These arrangements are often talked about as executive
compensation, but the rules really cover the broader umbrella of
deferred compensation," Drigotas added.
Employees, not employers, are penalized for mistakes with an
extra 20% income tax on the amount in question, along with another tax
in some cases. If an employer pays the penalty, that amount is
considered additional compensation.
For example, a person with $200,000 in a faulty arrangement
would have to include the $200,000 in his taxable income whether or not
he had access to it for that year, and pay both a 35% tax (assuming he
owes the top rate) and an additional 20% tax on the amount, for a total
federal tax of $110,000 or more.
Someone in that position "may come to the employer and say
'Hey, I didn't draft this document, I think I'll sue you'," noted
Drigotas.
And, it is very easy--in some cases ridiculously so--to trip
up. For example, the rules say documents should use the phrase
"separation from service," but a company may have instead used
"termination of employment" throughout. The new guidance appears to
give a pass for this kind of error, but there are still questions about
what will happen if the IRS finds an offending term on audit.
"Are you really going to impose a 20% penalty on all amounts because it says 'termination of employment'?" asks Drigotas.
Both Hogans and Drigotas said they expect to see more auditing
of the plans by the IRS in the future. "I think this is just the first
step," Hogans said of the recent trickle of audits he has heard about.
Section 409A was added to the tax code as part of the
American Jobs Creation Act of 2004, in large part to prevent a repeat
of the Enron scandal, when executives cashed out of their plans shortly
before the company went under. The IRS gave companies until the end of
2008 to comply.
The IRS could not immediately be reached for comment.
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