© 2015 Parker Poe Adams & Bernstein LLP

Par

ker

Poe

Ada

ms

& B

erns

tein

LLP

Att

orne

ys a

nd C

ouns

elor

s at

Law

409A Compliance

What  is ‘deferred compensation’?

And just what is the IRS looking for?

Michel Vanesse (Parker Poe Adams & Bernstein, LLP)Michael Hoes (Bank of America)

November 10, 2015

IRS Launches Limited Audit

Limited audit on 50 large employers

Model IDR gives an indication as to areas of focus

Deferral elections (limited to plans where participants voluntarily elect to defer receipt of compensation); applicable rules impose strict limitations as to when deferral elections are appropriately made

Subsequent re-deferrals (same limit); applicable rules impose even more severe restrictions on the ability to re-defer compensation

Permissible payment triggers (very limited list under applicable rules);

2

IRS Launches Limited Audit (Continued)

Requires employers to know what is covered by Section 409A Document production may prove difficult (IRS document

request refers to “all plans, agreements, methods, programs or other arrangements (such as employment agreements) maintained by the service recipient that are nonqualified deferred compensation plans within the meaning of Regulation §1.409-1(a)”)

Need to know what is properly excluded from Section 409A to avoid being over-inclusive

Initial step towards more wide-spread enforcement; Need to prepare

3

What We Will Cover Today

Quick reminder of scope and purpose of Section 409A

Emphasis on internal procedures and methods to reduce risk of non-compliance

Self-audits Interacting with HR, lines of business and other departments that

may have some decision power for compensation and benefits Managing service providers Managing participants

Q&As

4

Section 409A – Basic Requirements

Regulates the deferral, payment & funding of all deferred compensation

Legally binding right to compensation that COULD be paid in a later year

Even if the right is subject to vesting or other conditions

Focuses on timing of deferral (plan input) and on timing and form of payments (plan output)

Makes it very hard to make changes once the arrangement is entered into

Covers most “service providers” – employees, directors, even certain independent contractors

Addresses IRS’s concern over what it perceives as excessive control by taxpayers over the timing of recognition of income

5

Scope of Section 409A

Not just elective deferrals, but also: Equity compensation Supplemental retirement Employment agreements Severance pay Bonuses Indemnification/reimbursement agreements Change-in-control benefits Perks

As a result, Section 409A can potentially affect all areas of compensation.

6

Scope of Section 409A (Continued)

International reach Applies to U.S. taxpayers, including U.S. citizens and

permanent residents (green card holders) working abroad May therefore apply to foreign plans in which U.S. taxpayers

participate Applicable rules include several exclusions specifically

designed for foreign plans

As a result, Section 409A can even require coordination with foreign entities in a controlled group

7

Scope of Section 409A (Continued)

Complex set of rules Not intuitive Many terms of art with definitions that are created specifically for

this provision (stock right, separation from service, change in control, unforeseeable emergency, etc.)

Because the scope of Section 409A is so broad, applicable rules also include many exceptions with very specific requirements

Need to understand the total compensation & benefits landscape of each company (including foreign plans)

Need to monitor on an ongoing basis for changes and operations

Need to educate appropriate parties

8

Failure to Comply and Sanctions

A failure can occur as the result of: Operational failure – the plan is not administered according to

its terms and Section 409A Document failure – the plan is not drafted according to Section

409A

No exception for minor violations

Penalties for noncompliance are severe Owed by the service provider All vested deferred compensation is taxed immediately Additional 20% tax Interest for late payment of taxes at the underpayment rate

plus 1% Plan aggregation Other potential penalties imposed on the service recipient (for

example, in the event of failure to timely report income)

9

Failure to Comply and Sanctions (continued)

How far back can the IRS go? Normal application of the statute of limitations Generally 3 years

But what about ongoing violations? Need to distinguish among various scenarios Statute of limitations may start running in the event of an

accelerated payment in the form of a lump sum But an ongoing failure to pay an amount that has become due

may create a violation over multiple years

10

Failure to Comply – Not an Employer’s Problem?

Just because the penalties are imposed primarily on the service provider (employee) does NOT mean the employer should not be concerned

Most 409A-covered arrangements are for executives Many arrangements are not negotiated and the benefits that

are promised are NOT meant to be subject to the 409A penalties

Risk of law suits

Participants are generally not involved in plan operations Risk of human errors and computer “glitches” Expensive gross-ups?

11

Self-Audit – How To Prepare for the IRS

Initial step in the process of achieving Section 409A compliance includes the creation of a list of all compensation and benefits arrangements

Solely for purposes of identifying plans, programs, agreements and other arrangements, including one-person agreements (whether they are in writing or not)

May be a complex task in decentralized businesses

Next step involves an analysis of the design and operations of each arrangement

Determining Section 409A exclusions or otherwise assessing compliance

Goes beyond an analysis of plan documents; operations must reflect plan terms and comply with all applicable requirements under Section 409A (can prove time-consuming)

12

Self-Audit (Continued)

Generally requires engagement of multiple (non-legal) departments in a company

HR Line-of-business managers Other departments or functions with compensation and

benefits responsibilities

May require engagement of outside partners if certain functions are outsourced

Payroll Plan administrators Record keepers

May reveal different understandings of plan design and erroneous operations

Need to agree on response Plan amendments, corrections of errors

13

Self-Audit (Continued)

Will also require ongoing monitoring after the initial due diligence phase

Changes in design Errors Other special situations (hardships, domestic relations orders,

etc.)

Irrespective of the size of the employer, some formalization of the processes for the adoption and maintenance of compensation arrangements is beneficial

Education of individuals involved in compensation functions (including new recruits)

Safeguards against errors (409A policies, internal tools to spot issues, internal reporting obligations for problematic designs or errors, etc.)

Should lead to greater cooperation between lines of business and legal function to avoid mistakes

14

Correction of Failures

Errors will occur despite safeguards Unintentional errors (human errors or computer errors) Misunderstanding of complex rules

Types of failures: Document errors Excess deferrals Insufficient deferrals Accelerated payments Delayed payments Stock rights issues

Need to identify failures correctly and quickly Some errors are not necessarily 409A failures (such as late

payments made in the same calendar year) increased burden with the passage of time (mistakes can be

easy to correct, if correction is performed quickly after they occur, but a small error eventually can turn into a full blown violation)

15

Correction of Failures (Continued)

IRS has issued limited correction programs Document failures and operational failures Provide incentives for early detection (the IRS wants companies

to be proactive and perform internal audits regularly) Limited time window Generally not available during an IRS audit

Correction under IRS programs is VERY detailed and requires EXACT compliance

Also not intuitive No standardized methodology Certain aspects of correction are permissive and not

mandatory Depends on the type of error, the timing of the correction, the

individual affected by the error, the amount involved

16

Correction of Failures (continued)

Typical issues to be addressed during correction show a need for coordinated actions amongst multiple parties

Earnings and losses on benefit accruals Time value of money in the event of early payment Withholding taxes (repayment of net or gross amounts) Reporting obligations

Use of the correction program requires the service recipient to demonstrate that: Measures have been taken to make sure the failure does not

occur repeatedly, and The failure was inadvertent and unintentional

May be difficult to demonstrate if the same failure occurs over multiple years or on multiple occasions

17

Participant Communications/Cooperation

Full correction may require the cooperation of the affected participant(s)

Cooperation may be difficult when repayments are required Need to address difficult situations where the participant may

already have spent the money Correction program is rigid – Loans are not allowed

Penalties may still apply (on a reduced basis) even if full compliance with the correction program is achieved

18

Participant Communications/Cooperation (Continued)

Need to develop standardized responses for similarly situated employees Requires correction process to be fairly centralized Need to avoid bad precedents, which can create a perception

of discrimination among employees if different responses are applied to new situations

Need to develop strategies when dealing with uncooperative individuals Are there circumstances where it is okay to decide not to

correct and to deal with full blown 409A violations? Is a gross-up for all negative tax consequences ever to be

granted?

19

Service Provider Cooperation

Plan administration can be mostly performed by computer systems and many failures will be either system-driven or due to unintentional keystroke errors Need to carefully review how systems are programmed to

make sure they reflect plan terms

If plan administration is outsourced, the service agreement with the service provider, third-party administrator or record keeper should be analyzed carefully Erroneous programming Erroneous data Erroneous data entry Standard of liability Indemnification clauses

20

Service Provider Cooperation (Continued)

The interests of the parties may not be aligned and the parties may not be equally risk-averse or risk -prone

Possible disagreement as to whether or not there has been a failure

Need to determine measures to take in order to avoid repeated errors (correction requirement)

21

Conclusions

Is Section 409A the new “ERISA for non-qualified plans”? Equally complex More severe sanctions (mostly NOT on the employer) Similar need for correction programs because of exceedingly

complex compliance requirements and often disproportionate sanctions

Need to have a comprehensive view of all compensation and benefit plans (both domestically and internationally)

Need to determine compliance or exclusion from scope

22

Conclusions

Need to establish processes for safeguards to minimize the risk of errors and/or ensure a prompt reaction when errors do occur Educate the individuals involved in the design and

implementation of compensation and benefit programs Develop tools to spot issues Create internal lines of communication

Need to partner with other parties involved in compensation and benefits May be more difficult in companies that are fairly

decentralized Is likely to include outside service providers

Need to develop effective communication with participants

23

QUESTIONS???

•

Michael HoesGlobal Compensation & BenefitsBank of America214 N. Tryon StreetCharlotte NC 28255980.386.1624michael.hoes@bankofamerica.com

Michel VanesseParker Poe Adams & Bernstein401 South Tryon StreetCharlotte, NC 28202704.335.9040michelvanesse@parkerpoe.com

24