Last year, the IRS began auditing deferred compensation plans and arrangements under IRC Section 409A, which imposes restrictions on both the terms and the operation of such plans unless an exemption applies. This program began in 2009,  the first year that plan documents had to comply with  Section 409A  in writing (beginning in 2006, plans had to comply in operation only). The program will include 6,000 random audits of employer-sponsored NQDC plans and will run through the end of 2012.

Even though the audit program is relatively new, practitioners have informally shared anecdotal evidence on which  issues the IRS appears focused on so far. The list of issues below is not exhaustive and other issues may be raised, depending on the nature and identity of the employer and its NQDC arrangements.

In general, however, it appears that the IRS is requesting detailed documentation on the following areas (i) if a plan intends to rely on the “short-term deferral” exception, the plan clearly must disclose the relevant terms, including detailed information on any forfeiture risks, (ii) employees’ initial and “second” deferral elections must include specific terms for making elections, and  specify both the initial and new payment dates, (iii) plan documents must provide detailed information on any events that would trigger the acceleration of benefit payments, particularly events triggered by an employer’s deteriorating financial condition, and (iv) plans’ treatment of “specified employees,” (certain senior executive officers of publicly traded companies) who are subject to the general rule that payments cannot begin earlier than six months after termination of employment. Plan documents must clearly identify which employees are “specified employees” and plans must maintain detailed records of such employees’ termination dates and the dates on which payments began.

Section 409A imposes harsh penalties on employees who benefit under NQDC plans that do not satisfy Section 409A’s documentary or operational compliance rules. Violations can subject employees to immediate income tax on deferred amounts, a 20% penalty tax and a “premium interest” penalty. To protect employees against these harsh sanctions, some employers agree to pay some or all of the tax cost to an employee who is penalized under tax "gross up" provisions. Thus, 409A violations can trigger both employer and employee tax liabilities.

Clients that maintain NQDC arrangements even if they have initially reviewed their documents for Section 409A compliance before the documentary compliance rules took effect in 2009, may wish to re-review their plans  in light of the areas in which the IRS initially appears to be concentrating. Plans that correct documentary or operational defects voluntarily before receiving notice of an audit often, under the IRS’s voluntary compliance program, can settle such issues with the IRS for significantly reduced sanctions.

Even if an employer receives an audit notice under Section 409A, it still may be able to negotiate limits on the scope of the audit by agreeing in advance with the examining agent on which subjects will be covered and which documents must be produced. Such agreements can greatly reduce the cost of the audit and  the paperwork burden on employers. Having all NQDC documentation organized and readily accessible to the agent also can help minimize audit costs and administrative burdens.