IRS issues guidance on deferred comp tax

The US Internal Revenue Service has issued new guidance on a section of the tax code dealing with deferred compensation. For GPs who don’t have their documents in order on this complex issue, the new guidance – and the grace period in which they can correct any documentation errors – will be welcome.

In January, the IRS issued a notice that allows employers to correct certain documentation errors for a nonqualified deferred compensation plan to comply with Section 409A of the Internal Revenue Code, and provided guidance on 409A compliance. Employers have until 31 December to make any necessary correction, and don’t have to pay any penalty or unnecessary tax.

Previously, the IRS had allowed employers to make operational corrections, but not documentation corrections. The penalties for getting either wrong can be harsh: an additional 20 percent 409A tax on top of what is already owed, along with accelerated taxation of the deferred payment and “premium” interest rates on the amount owed.

“This new program allows you to correct certain document failures,” said Ira Bogner, a tax partner at law firm Proskauer Rose. “It enables people who may have created a small (or maybe not so small) faux pas in their drafting to fix it in a way that potentially avoids additional income inclusion.”

Typical “qualified” deferred compensation plans are plans like Roth IRAs or 401-Ks. But there are several methods of compensation common to the private equity world that would fall under the definition of “nonqualified” deferred compensation plans. During tax season, CFOs would do well to consult with their tax attorneys to make sure they understand where their compensation agreements fall.

“It’s a hyper technical statute, there are some weird rules that surround it, there are draconian penalties for failure to comply with it,” said Rich Walton, of counsel at law firm Buchalter Nemer.

One private equity compensation structure that could come under scrutiny is “phantom carry”, where junior employees get a bonus that is tied to the amount of carry that the senior partners are paid. This type of income can fall under Section 409-A, said Bogner. Creating a phantom carry arrangement that complies with 409A can be very difficult, he added.

“From what I’ve seen in my private equity fund manager clients, there is a large component of deferred compensation under an unqualified deferred compensation plan,” said Walton.

He adds that the new guidance allowing employers to mend their ways is a signal that the IRS is going to be scrutinising deferred compensation plans in the near future, much as the service cracked down on the use of offshore tax “havens” last year.

“There’s a big effort underway to tighten down on ERISA plans, deferred compensation plans, and so forth,” he said. “Whenever the IRS is going to put a microscope on a certain sector of the economy, they give taxpayers some sort of an opportunity to voluntarily get it right.”