(Dow Jones) Tax lawyers want the IRS to lighten up on corporate executives when honest mistakes are made in their deferred pay plans.
Right now, those executives face heavy tax penalties from even small, and often widely occurring, errors. So the American Bar Association's tax group is asking that the Internal Revenue Service relax parts of the tax code's section 409A, which covers deferred compensation plans.
Stock options and plans linked to other plans are a special concern for the group, which asked in a letter for more leeway to correct errors without heavy taxes on employees.
Althea R. Day, a partner in the Washington, D.C., office of law firm Morgan Lewis, helped draft the letter. She works with companies that have compensation plans and says that she and colleagues share a sense that "you can see potential document failures in every document."
The glitches are often small, inadvertent missteps such as a wrong phrase to describe an aspect of a pay package. And they are already "catching so many folks by surprise," said Eleanor Banister, a partner in the employee benefits and executive compensation practice in the Atlanta office of the law firm King & Spalding, and another drafter of the letter. In many of these cases, she added, "nobody realized the language in the contract was violating 409A."
The IRS declined to comment. It is already working on making 409A less onerous and on giving employers and employees a chance to correct some errors without penalty; in fact, the ABA letter was submitted as part of a process the agency has under way to that effect.
The 409A rules are complicated and easy to trip over. But it is the employee, rather than employer, who foots the formidable tax bill when something goes wrong.
Employees are penalized for mistakes with an extra 20% income tax on the amount deferred, which could fall on top of regular income tax of up to 35%. If an employer pays the penalty, that amount is considered additional--and taxable--compensation.
Mispriced stock options are a potential problem under 409A. For an employer that grants a stock option on its company stock this year and misprices it at, say, $4.95 instead of $5, the employer would have until Dec. 31, 2010, or Dec. 31, 2011, to correct it, depending on his status. If the mistake isn't caught in time, "the option can't be corrected under the guidance," said Elizabeth Drigotas, principal, Deloitte Tax LLC.
Linked plans are another big potential problem. As many as half of nonqualifed compensation plans may be linked to other plans, including supplemental retirement plans or excess benefit plans. Changes to one plan may mean changes to a linked plan that could mean trouble.