The Internal Revenue Service (IRS) announced in September 2009 that it would conduct random payroll tax audits of 6,000 companies. The audits will include a focus on compliance issues relating to Section 409A of the Internal Revenue Code of 1986. The IRS enacted Section 409A in 2004 to reform nonqualified deferred compensation that is earned during a taxable year but might be payable in a later taxable year.

"It’s not clear when the audits will start, but they will be ongoing over three years," says Scott Landau, a partner at Pillsbury Winthrop Shaw Pittman. "The pressure on the IRS to collect taxes that have previously fallen between the cracks as well as the current focus on executive compensation by Congress, the Treasury Department, the Securities and Exchange Commission, and the press has put the spotlight on employee-related tax issues."

In other words, payroll and compensation practices and procedures will be under minute scrutiny.

"To be ready for such audits, employers should review worker classifications, fringe benefit policies and nonqualified employee benefit plans now," Landau says. "Such reviews may allow companies to proactively correct problems before an audit, and provide assurances to executives and other employees that they will not likely be subject to 409A penalties or other penalties."

The reviews may also give employers the opportunity to qualify for significantly reduced penalties for noncompliance with 409A rules (see "EPCRS Explained").

"Correcting errors before an audit may result in smaller penalties than if the errors are discovered during the audit," Landau says.

On the other hand, the reviews can be complex and time-consuming, and can involve a re-evaluation of processes as well as documentation.

"The difficulty in the employment and benefits tax area is that so many departments—benefits, legal, tax and payroll to name just a few—touch on the issues," says Anne Batter, vice chair of Miller & Chevalier’s employee benefits group. "And they might not be fully coordinated in terms of what needs to happen."

And the devil could be in the details. The IRS focus on fringe benefits, for example, could include audits of such minutiae as transportation perks, education assistance and even employee discounts.

"Employers should review all executive and nonexecutive fringe benefits and expense reimbursement policies and procedures for any discrepancies that could have monetary implications for the company or its employees in an audit," Landau says.

In an economic climate that breeds downsizing, a close look at worker classification is a must. The categorization of individuals or relationships as "independent contractors," for example, merits a close examination because it can directly impact tax withholding and benefits issues, federal and state tax liabilities, unemployment tax liability, health and welfare benefits obligations, code-qualified benefit plan participation and IRS penalty exposure.

"It’s not uncommon for companies to drastically reduce their workforce and then find that the same individuals are doing the work and have been reclassified as independent contractors," Landau says. "But just calling them individual contractors doesn’t make them so."

Employers will have to ensure not only that agreements have been properly drafted but also that the facts and circumstances on the ground justify the classification. The issue is not a simple one.

"A wide variety of facts and circumstances will determine whether an individual is an employee or independent contractor," Landau says. "Ultimately, the question is whether or not it is the company that controls or directs the individual or entity said to be an independent contractor."

Dealing with Section 409A documents and practices may prove to be the most demanding aspect of the IRS audits for employers. They’ll have to be very careful: Violations of the statutory rules carry severe penalties, including a 20 percent additional tax and interest at 1 percent above the IRS’s underpayment rate.

Further complicating matters, audits will likely embrace 2006 and 2007 although employers were not subject to full documentary compliance with Section 409A until Dec. 31, 2008. The IRS is currently formulating 409A audit guidelines for 2006-2008, Landau says.

In addition, many companies still are not clear on certain aspects of the 409A rules, particularly those relating to foreign employees and U.S. employees working abroad.

To deal with these issues, lawyers are advising employers to review all deferred compensation plans for documentary compliance, all deferral elections, potential payment accelerations and any stock-
related awards subject to Section 409A.

"It’s also important to affirm the integrity of the process," Landau says. "Employers should ensure that there has been a proper delegation of authority from the board through to the HR team, that roles and responsibilities have been properly defined, what the materiality thresholds will be and how the decision-making process will work going forward."

Because the IRS has just begun to ask questions, there’s still time to make the corrections, Batter says.

She also believes that the publicity surrounding deferred compensation reform likely means that the vast majority of employers are in compliance.

"Anyone that didn’t catch the wind by the end of 2008 was living under a rock," she says.

While in-house counsel can contribute significantly to the review process, it’s prudent to have an independent third party involved. There are cost considerations, however.

"The cost for [outside counsel] to dig deep, do a broad audit and engage in a certain amount of cleanup can range from approximately $50,000 to $200,000 depending on the complexity of the employee benefit and compensation plans and programs and the problems discovered," Landau says.

If that’s a bit steep for some, in-house counsel can focus on certain limited areas to determine if problems exist.

"A limited audit can be a good gauge to give employers a certain level of comfort," Landau says.

But if problems appear, companies are better off coming clean now.

"It’s the proverbial ounce of prevention," says Richard Walton, of counsel at Buchalter Nemer. "Spend now and the cost is likely to be a lot less than if you wait until after the audit to fix the problem."