Tax Law Blog

Avoid Taxes and Penalties on Your Business’s Compensation Arrangements

Has your business promised to pay a benefit to an employee or an independent contractor at some time in the future? If so, your promise may be subject to the complex rules of Section 409A of the Internal Revenue Code.

The IRS’s standard audit procedures include auditing compensation arrangements for Section 409A compliance. If a compensation arrangement doesn’t comply, your employee can be immediately taxed on the benefit you promise, charged interest, and charged a 20% penalty. The IRS can charge your business penalties and interest for withholding insufficient income and employment taxes and improperly reporting your employee’s compensation.

Section 409A can apply to any arrangement that could result in compensation being paid in a year after the year in which it is earned. This includes most traditional “nonqualified deferred compensation plans” (for example, supplemental executive retirement plans or SERPs, phantom stock plans, and stock appreciation rights plans). It can also include bonus programs, employment and consulting agreements, severance programs, management and administrative services contracts, stock options, stock incentive plans, and other compensation arrangements.

Fortunately, the IRS allows employers to voluntarily correct Section 409A violations in certain circumstances. In many cases, the IRS allows voluntary correction without requiring payment of taxes or penalties. Accordingly, employers should consider having their bonus programs, employment agreements, formal deferred compensation plans, and other compensation arrangements reviewed by a qualified tax lawyer.

Categories: Employee Benefits, Tax