• The Time to Act Is Now: IRS Audit Initiative and Last Chance for Deferred Compensation Plan Corrections
  • March 31, 2010 | Authors: Stephen F. Herbes; James N. Karas
  • Law Firms: Riker Danzig Scherer Hyland & Perretti LLP - Morristown Office ; Riker Danzig Scherer Hyland & Perretti LLP - New York Office
  • I. IRS Launches New Audit Initiative: Impact on Employee Benefits, Executive Compensation and Fringe Benefits

    The Internal Revenue Service has launched a new audit initiative focusing on employment tax issues ranging from executive compensation to fringe benefits. The audits focus on four main areas: worker classification/independent contractors; executive compensation; fringe benefits; and payroll taxes. The audit initiative could have a major impact on the rights of misclassified workers, including their right to employee benefit coverage.

    Right to Employee Benefits

    The worker classification/independent contractors portion of the audits concentrates on the frequent misclassification of employees as independent contractors. According to the IRS, this portion of the audit may be expanded to cover three-party relationships, W-2 vendors and staff leasing relationships.

    The reclassification of workers from independent contractors to common law employees can have an unintended and heavy impact on the rights of misclassified workers to employee benefits - an impact that came into sharp focus in the Microsoft case (Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997)). In Microsoft, the software giant allegedly required independent "freelancers" to sign agreements acknowledging that they were independent contractors (i.e., not employees) and ineligible to participate in Microsoft's employee benefit plans. After Microsoft's former workers who had been misclassified as "independent contractors" were reclassified by the IRS as common law employees, they sued Microsoft demanding full employee benefits for the time they worked as independent contractors. The Ninth Circuit Court of Appeals held that the workers could not be excluded from Microsoft's benefit plans (including a 401(k) plan and discount stock purchase plan) because they were considered common law employees, not independent contractors.

    As seen in the Microsoft case, the failure to properly classify workers can result in substantial financial obligations on the part of the employer. Not only may the employer be forced to pay additional FICA, FUTA, and withholding taxes, but employees improperly classified as independent contractors may bring suit against their employer to recover denied benefits.

    Executive Compensation and Fringe Benefits

    In addition to the worker classification/independent contractors portion of the audit, auditors will also focus on taxable compensation in the form of loans to executives, executive travel, nonqualified deferred compensation plans, retirement contracts, equity-based compensation, and golden parachutes.

    Fringe benefits will receive close scrutiny, including such traditional fringe benefits as company cars, payment of club dues, spousal travel and housing. In addition, the IRS has indicated that it may seek to challenge more broad-based noncash fringe benefits like expense reimbursement arrangements, gift cards, working condition fringes, club memberships, employer cafeterias, and athletic facilities.

    Because the audits are structured as payroll tax audits of Forms 941, they will focus on more traditional employment tax inquiries, including next-day deposit requirements, backup withholding, B Notices and Form W-2/Form 1099 compliance.

    The audits, which will cover all industries and company sizes, will mainly focus on the 2007 and 2008 tax years and will include audit questions, face-to-face interviews, and a line-by-line review of a company's employment tax returns. Companies who have already received a first round of audit questions confirmed that several of the questions focused on deferred compensation, equity payments and fringe benefits.

    Recommended Action

    To prepare for an IRS audit and minimize the likelihood that misclassified workers will bring suit against the employer to recover denied employee benefits, each employer should:

    • review the status of every employee and independent contractor to ensure that employees are not improperly classified as independent contractors;

    • review employee benefit plan documents to ensure that any reclassification of independent contractors as common law employees will not result in retroactive coverage or a right to retroactive benefits;

    • review loan and executive compensation programs to determine whether they have been correctly reported to the IRS and otherwise comply with the Internal Revenue Code and IRS guidance;

    • review the company's fringe benefit programs and determine whether the programs comply with the Code and IRS guidance;

    • review the company's Forms 941 and other tax-related documents to ensure compliance with IRS reporting requirements; and

    • review nonqualified deferred compensation plans for compliance with Code section 409A.

    II. Last Chance to Correct Plan Documents to Comply with Code Section 409A

    Section 409A of the Internal Revenue Code imposes draconian sanctions for non-compliance, including a 20% excise tax and accrued interest. The IRS recently released Notice 2010-6 (the "Notice"), which provides guidance on correcting plan document failures under Code section 409A. Previously, the IRS had permitted correction of only operational failures, specifically excepting plan document failures from such correction. The Notice encourages employers to review their nonqualified deferred compensation plan documents to confirm they comply with Code section 409A and to correct them, if necessary, by December 31, 2010.

    In order for a nonqualified deferred compensation plan to be eligible for correction under the Notice, certain conditions must be met:

    • only inadvertent or unintentional failures may be corrected;

    • all similar failures must be corrected;

    • the employer's tax return must not be under examination with respect to nonqualified deferred compensation, and the employee's tax return must not be under examination;

    • the employee must pay all taxes associated with the Code section 409A correction; and

    • the employer must satisfy all information and reporting requirements.

    The Notice identifies a number of plan document failures that may be corrected, including the following failures:

    • an impermissible definition of a permissible payment event;

    • an impermissible payment period;

    • an impermissible payment event or payment schedules;

    • an impermissible initial deferral election;

    • the failure to include a six-month delay period for specified employees; and

    • an ability to correct certain errors in the year in which the employer adopts a plan.

    The Notice provides special transition relief for the corrections allowed under the Notice, stating that if the correction is done on or before December 31, 2010, the plan is treated as having been corrected on January 1, 2009.

    A few provisions in the Notice raise additional concerns that should be carefully considered by employers or their advisors when reviewing the employers' nonqualified deferred compensation plans. For example, the Notice indicates that the phrase "termination of employment" may violate Code section 409A if it leads to payments in situations not permitted under Code section 409A (e.g., payment upon reduction in an employee's hours or the rehire of an employee as an independent contractor providing significant services after termination of employment). Moreover, the Notice indicates that severance payments contingent on a release of claims or the end of a rescission period may violate Code section 409A (if the compensation to be paid is subject to Code section 409A).

    If a nonqualified deferred compensation plan contains ambiguous terms (e.g., payments will be made "as soon as possible"), the plan may be deemed to have violated Code section 409A if the employer has a practice of interpreting the term in a manner that violates Code section 409A. The Notice provides that these terms may be corrected by adding a savings clause (e.g., any ambiguous language will be interpreted in a manner that complies with Code section 409A) or by revising the language to comply with Code section 409A.

    Recommended Action

    Employers should:

    • work with legal counsel in reviewing nonqualified deferred compensation plans to ensure that the plans comply with Code section 409A;

    • correct any noncompliant plan provisions no later than December 31, 2010.