IRS Eyes Wall Street Deferred Comp

(Dow Jones) The U.S. Internal Revenue Service is taking a look at compensation plans that hold a lot of the big money Wall Street firms pay out to executives.

Major accounting firms and tax attorneys are instructing firms on how to prepare for a wave of audits they expect for deferred compensation plans. Executives themselves face stiff tax penalties when employers run afoul of the rules.

Susan Lennon, managing director of the human resources service group at PricewaterhouseCoopers LLP, predicts that IRS audits of deferred compensation plans will increase in "number and scope."

Reviewing how stock is valued in plans, how qualified and nonqualified stock plans are administered, and whether old plans have been grandfathered properly are among the things an employer can do to get ready for an audit, Lennon said. The legal, tax and human resources experts at a firm all need to coordinate during executive compensation audits, she said.

A first line of IRS review will likely be on whether plan documents satisfy basic requirements, according to Daniel L. Hogans, a former Treasury tax policy attorney who helped draft the Section 409A regulations of the tax code, which established strict deferred compensation rules. Last month, the IRS said it would give limited opportunities to correct certain kinds of document errors, potentially sparing some people heavy tax penalties.

Section 409A went into full swing last year and the tax authority apparently wants to make sure employers are obeying it. There is still a lot of confusion on the part of companies and their tax advisors over how to comply. Nonetheless, an audit is a "very binary" process, according to Hogans.

"This is not horseshoes," he said. "Close does not count, as a matter of pure legality."

The IRS did not immediately comment.

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% penalty tax, for a total federal tax of $110,000 or more.

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.

Right now, companies do not have to report how much they defer into compensation plans. They will eventually have to under Section 409A, once the IRS resolves some issues on valuing yearly compensation.

Nonetheless, the amount of money going into deferred compensation plans may have gone up last year. Wall Street bonuses paid to New York City securities industry employees rose 17% to $20.3 billion in 2009, according to an estimate by New York State Comptroller Thomas P. DiNapoli last week. The figure, based on tax collections, reflected cash bonus payments and deferred compensation for which taxes have been prepaid.