A nonqualified deferred compensation plan can help attract and retain your key staff in today’s competitive economy. However, compliance with Internal Revenue Code Section 409A can be complicated, the penalties are extremely punitive, and the IRS has no policy to negotiate settlements. Here are a few things to keep in mind as you navigate 409A compliance.
Common Section 409A errors and penalties
Companies tend to make a number of errors when it comes to Section 409A compliance, including:
- Incorrect calculation of plan deferrals and distributions
- Failure to make deferral or distribution elections in a timely manner
- Failure to comply with Section 409A definitions for specified terms
- Early payment of an amount payable in a later year
- Late payment of an amount payable in an earlier year
Fortunately, the IRS has a correction program that can minimize or even eliminate Section 409A penalties.
Unfortunately, with errors come significant penalties, including:
- Immediate income recognition of the participant’s entire plan balance (the “taxable amount”) with respect to the year of error
- Potential late payment penalties and interest on the taxable amount
- Additional 20 percent excise tax and “premium interest tax” on the taxable amount
- Potential late penalties and interest on failure to withhold
- Restating and refiling previous years’ tax forms (e.g., Forms W-2 and 1099 for companies and Form 1040 for plan participants)
Fortunately, the IRS has a correction program that can minimize or even eliminate Section 409A penalties — if they’re identified and corrected within two calendar years following the error. So, don’t wait; the longer you wait, the greater the possibility of an IRS audit and the more likely penalties would be assessed.
Cost savings with Section 409A error correction
Imagine a biotechnology company with a nonqualified deferred compensation plan whose research manager has a $500,000 aggregate plan account balance. If a Section 409A error with a value of $50,000 occurs, the following table illustrates the dramatic difference in penalties and filing requirements, depending on if and when an error is proactively addressed (assuming a 2 percent AFR rate):
Uncovering errors and navigating through the correction procedure oftentimes requires a trusted expert to help with the process. If you’ve been struggling — don’t. Give us a call. We’re here to help.