A day late, a penny short
Egar Adkins has devoted roughly half of his working hours this year to ensuring that his clients meet all their obligations under a 2004 Internal Revenue Service (IRS) code change that will go into effect December 31 when the transition relief period finally ends. He figures that by the time you read this, 75 percent to 100 percent of his time will be dedicated to navigating the complexities of Section 409A. Adkins, a partner in Grant Thornton’s national tax office in Washington, DC, is one of a small army of specialists making sure companies haven’t missed any points of compliance with a requirement whose structure is so complicated that it’s difficult not to drop a stitch somewhere.
‘I think a lot of companies, maybe even most companies at this point, are on top of 409A as it relates to traditional deferred compensation plans,’ says Adkins, who also chairs the American Institute of Certified Public Accountants’ (AICPA) employee benefits tax technical resource panel. ‘I think what they’re not on top of are plans that they don’t think of really as being deferred compensation, but in fact they are plans that fall under these rules.’
A quick explanation of 409A seems easy enough to understand. As the IRS describes it, the rule ‘applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as non-qualified deferred compensation. … If deferred compensation meets the requirements of 409A, then there is no effect on the employee’s taxes. The compensation is taxed in the same manner as it would be taxed if it were not covered by 409A. If the arrangement does not meet the requirements of 409A, the compensation is subject to certain additional taxes, including a 20 percent additional income tax.’ The challenge companies face as the deadline approaches is that while these basic rules seem straightforward enough, they raise more questions than they answer.
Martha Steinman is a partner at the New York law firm Dewey & LeBoeuf, where she co-chairs the firm’s global compensation, benefits and employment department. ‘Because of the complexities, the thinking on how to handle things just continues to evolve, so the interpretations are very complicated,’ she says. ‘A lot of the guidance has evolved informally. We have the regulation, but there hasn’t been a lot of formal guidance beyond that, even though there are innumerable interpretive questions.’ She estimates that every lawyer in her team is working on the issue at this point and will be through the end of the year.
Specialists echo one another in their descriptions of the rule as burdensome, pervasive and more far-reaching than most companies realize. ‘This hits many arrangements unexpectedly,’ says Joni Andrioff, a principal at the Chicago office of Deloitte, where she heads the global employer services/tax practice. She notes that many of the arrangements covered under the rule would not have been classified as deferred compensation before 409A. ‘There was an education process as to what kinds of arrangements were subject to the law.’
A complicated picture
Full compliance demands much more of a company than simply finding and analyzing all its deferred compensation plans, employment agreements, and change of control agreements.
The rule also has an impact on the company’s policies regarding matters like bonuses and even expense reimbursement, says Steinman, who chairs the American Bar Association’s (ABA) business law section committee on employee benefits and executive compensation. Every time her team at Dewey & LeBoeuf looks at a client’s paperwork, she says, they’ll discover a cross reference along the lines of ‘under the company’s policy regarding such-and-such.’ Each of those cross references sparks the response: ‘Is that a written policy? We want to see it.’
Adkins offers another example of something he thinks ‘is going to sneak by’ many companies: the financial planning benefit often provided to executives. ‘That’s a taxable fringe benefit … reported on the executive’s W2 as income. That’s fine; companies do that. Where they’re going to get into an issue, though, is if they allow a carryover of that benefit. Under 409A, that’s considered a deferral of compensation subject to the rules.’ He adds that compliance itself is not the issue in this case; the problem is that companies may inadvertently overlook the need to bring a benefit of that kind into its compliance program. ‘Given the complexity of the rules, you’re not going to accidentally comply. You have to know what you need to do to comply,’ he says.
Fringe payments and benefits cause problems
Andrioff, who is vice chair of the ABA tax section’s employee benefits committee, points out that the new rule also has an impact on termination agreements that call for the company to continue to provide medical benefits past the 18-month limit allowed by federal law under the Consolidated Omnibus Budget Reconciliation Act (COBRA), a circumstance that is ‘very typical’ under change of control agreements, for example. ‘That’s subject to 409A and has to fall into one of the exceptions if you don’t want it to be subject to the additional tax,’ she says. She has yet another note of caution: ‘One area that we found here that eluded some people is expatriates who get payments when they return to the US. That was a surprise.’ Prior to the rule, that would not have constituted deferred compensation.
The upshot is that on January 1, 2009, some companies that thought they had achieved full compliance are going to find out they have not.
Others may find that although they got their plans together in time, they neglected a small detail that will throw them into violation, notes Paul Wessel, a partner at the New York headquarters of Milbank, Tweed, Hadley & McCloy and head of the firm’s compensation and benefits group. He reminds companies to keep holiday work schedules in mind as they finalize their compliance plans. ‘You may need employee consent or approval if, for example, we’re talking about an employment agreement or an individual award of restricted stock or some other right to which an individual has contractual entitlement,’ he says. Signing will probably be in employees’ own interest and they may have no objection to granting consent. But the company that waits to ask for that signature until the last week of the year will be in trouble when it finds some employees have taken vacation and aren’t there to sign. Similarly, Wessel urges companies to keep track of which amendments will require board-level approval.
With so many prospective trap doors in the works, companies may feel as though they’ve been set up to fail, but Steinman doesn’t believe that was the intent of Congress, the Treasury Department or the IRS. ‘I think that when the statute was drafted and enacted, there was a lack of understanding of the mammoth beast they created and the implications of what they created in terms of how broad and far-reaching it was,’ she says.
Don’t rely on the kindness of the IRS
In recognition of those challenges, the IRS has already rolled out a ‘limited corrections program,’ says Adkins. ‘They are working on a more permanent, more robust corrections program where if certain things happen, they’re going to let you fix them with either no penalties or limited penalties.’
However, he advises companies not to rely on ‘the IRS’ benevolence’ to forgive compliance lapses. ‘If companies aren’t ready and don’t have the work done by the end of this year when the deadline comes and goes, I don’t think the IRS will hesitate to assess the 20 percent penalty against the executives who participate in those deferred compensation plans.’
Andrioff agrees. ‘My understanding is that IRS agents have been trained to audit for 409A in routine audits,’ she says. Audit results are harshest for companies that engage in deliberate non-compliance, while those found to have made an honest omission or mistake ‘might get a break.’ Although that may be true, she warns, ‘I wouldn’t look for that much leniency.’
Make an effort
For that reason, experts agree, companies must not give up on attempting to come into compliance by the end-of-year deadline. Although an incomplete program will still fail the compliance test, the consensus is that for a company that’s really neglected its 409A obligations, something is better than nothing.
Steinman suggests one strategy for those in an 11th hour panic: sending blanket notifications with a negative consent that states the ways in which the employee’s agreement is amended along with instructions to contact the company with any questions. Another option could be to adopt some kind of blanket resolution. ‘Will it fly in an audit? I don’t know. But I think anything you try is better than nothing,’ she says. ‘I think the worst mistake would be to stick your head in the sand at this point.’
Wessel, who chairs the ABA business law section’s executive compensation subcommittee, sounds a similar note. Even if you’re desperate and not going to make the deadline, do what you can to at least create evidence of attempts to comply, he advises, ‘to try to give yourself at least a good faith argument later or possibly avail yourself of a corrections program if the IRS ever did adopt something.’
Finally, as the January deadline approaches, companies need to understand the limits of their own knowledge of 409A and what compliance entails. Even large companies with extensive and specialized internal resources will find that their legal and accounting executives need time to educate themselves and get up to speed on what a compliance program needs to encompass. ‘Someone with knowledge of the scope of the law should be doing the review and inventory of the arrangements,’ Wessel says. That will allow the company to do an accurate analysis of its situation and make whatever changes necessary to achieve full compliance.