Targeted IRS Examinations of Section 409A Compliance

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Lois Wagman Colbert, Esq., Charles E. Hodges, II, Esq., William J. Vesely, Esq., Mark D. Wincek, Esq., Jennifer S. Schumacher, Esq., and Sarah N. Lowe, Esq.

Kilpatrick Townsend & Stockton LLP, Charlotte, NC, Atlanta,
GA, Washington, D.C., San Francisco, CA

Targeted IRS examinations of nonqualified deferred compensation
arrangements for compliance with Code §409A have been anticipated
for years. Until recently, §409A audit activity has occurred as
part of an examination of an employer's tax return.  However,
the IRS has commenced specific §409A examinations of select large
employers. The results of these audits will be used to refine and
further target future IRS enforcement activity under §409A. What we
are seeing is the first phase of an ongoing §409A enforcement

In light of this development, employers should review their
§409A compliance and take action to correct errors to the extent
possible in advance of an IRS examination. There are two formal IRS
correction programs for §409A errors, which cover a range of errors
and offer reduced/eliminated penalties for sponsor self-corrections
(but that require action before an audit is commenced):

  • Notice 2008-113 (operational errors)
  • Notice 2010-6 (documentary errors)

Prior IRS audit activity has focused on key §409A problem areas,
such as:

  • Impermissible payment triggers (e.g., signing of a release of claims)
  • Six-month delay and identifying "specified employees"
  • Faulty reliance on short-term deferral exception
  • Bad "good reason" definition
  • Lack of 409A "savings clause"
  • Accelerated vesting of equity and cash awards on "retirement"
  • Application of the 409A "substitution rule" (particularly in severance

An IRS examination typically begins with an Information Document
Request (IDR) that lists documents that the employer must produce
for the IRS to review as well as questions that the employer must
answer. Under new procedures, the IRS generally interviews the
taxpayer before issuing an IDR in order to gain more insight into
the issues the IRS plans to focus on during the examination. As
outlined in the attached presentation, we strongly advise employers
to consider outside representation to meet with the IRS in
appropriate situations to provide the employer with an experienced
advocate and critical insulation.

There are limitations on the documentation that an employer is
required to provide to the IRS, so an employer should carefully
consider the scope of an IDR before responding. In addition,
employers should be cautious in answering the questions set out in
IDRs. Section 409A IDRs have been extremely detailed, effectively
requiring the employer to take specific legal positions on §409A
compliance to respond. In most cases the examination will involve
interviews of employees involved in §409A compliance. These
interviews should be approached strategically. Careful preparation
of the witnesses based on experience with IRS interview procedures
and content can be extremely beneficial.

Please click here to see the attached presentation regarding how
to handle an upcoming IRS examination of an employee benefit

We have long recommended that employers undertake §409A
self-audits periodically to ensure compliance and to minimize
exposure from an IRS examination. However, self-audits are now more
important than ever. For more information about how to conduct a
§409A self-audit or how to approach an IRS examination of §409A or
other issues, please contact the authors of this Legal Alert or
your existing firm contact.

For more information, in the Tax Management Portfolios, see
Brisendine, Drigotas and Pevarnik, 385 T.M.
, Deferred
Compensation Arrangements, and in Tax Practice Series, see
¶5710, Deferred Compensation Tax Concepts and Structures, ¶5715,
Taxation of Nonqualified Deferred Compensation Plans - Sections
409A and 457A.

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