Section 409A of the Internal Revenue Code imposes a complicated set of rules and requirements upon any “nonqualified deferred compensation plan.” Failure to comply with the requirements of Section 409A will result in an additional federal income tax of 20%. This 20% tax is in addition to any regular income taxes payable; and state law may add additional taxes for any failure to comply with Section 409A. In California, nonqualified deferred compensation that does not comply with Section 409A is subject to an additional state tax of 20%. Therefore, compensation payable pursuant to a noncompliant deferred compensation plan in California could be subject to standard California income taxes of up to 13.3%, plus California Section 409A taxes of 5%, plus standard federal income taxes of up to 39.6%, plus federal Section 409A taxes of 20%.
It does not require an advanced degree in taxation to conclude that Section 409A is a potential catastrophe. It is therefore important to know, in general, when Section 409A may apply and what it requires.
When Does Section 409A Apply?
The requirements of Section 409A apply to any nonqualified deferred compensation plan. However, the additional Section 409A penalties only apply with respect to nonqualified deferred compensation plans that do not comply with certain requirements. A nonqualified deferred compensation plan is any agreement, method, program, or other arrangement that provides for the deferral of compensation other than a qualified plan. (Examples of qualified plans include: a 401(k), tax-deferred annuity, simplified employee pensions, etc.).
A plan provides for the deferral of compensation if, during one taxable year, an employee is provided a legally binding right to compensation that is not payable until a later taxable year. However, there is no deferral of compensation if the plan requires compensation be paid by the 15th day of the third month following the close of the taxable year during which the employee obtains a legally binding right to such compensation. NOTE: Although this article references “employees” in several places, Section 409A is equally applicable to independent contractors.
Arrangements Specifically Excluded From Section 409A
There are a number of deferred compensation arrangements which are exempted from the requirements of Section 409A. For example, Section 409A does not apply to severance agreements that only require payments on an involuntary separation or a termination for good reason (i.e., a constructive termination) if (i) the payments do not exceed the lesser of two times the employee’s annual compensation or $530,000, and (ii) the plan requires all payments be made by the end of the second year following the year of termination.
Stock options are exempted from Section 409A if, amongst other things, the exercise price of the options is at least equal to the fair market value of the shares on the date the option is granted.
What Does Section 409A Require?
The principle requirement of Section 409A is to limit the payment of deferred compensation to the occurrence of one of six events. In other words, a plan that provides for deferred compensation must defer payment of that compensation to the employee until the occurrence of one of these events. These events are:
- The employee’s separation from service.
- The employee becoming disabled.
- The employee’s death.
- A specific date or schedule identified under the plan.
- A change in control event.
- An unforeseeable emergency.
Treasury Regulations provide detailed rules as to when each of the foregoing events is or is not deemed to occur. It is critically important that any deferred compensation plan strictly conform to these regulations. Additionally, simply referencing the Treasury Regulations and stating that the plan is to be read to be consistent with such regulations is not sufficient.
Furthermore, the plan cannot allow for an acceleration or additional deferral of compensation payments except in limited circumstances.
If you believe your company may have a Section 409A issue, we invite you to contact Mr. Badyal by phone at 619-500-4540 or by email at firstname.lastname@example.org for a free initial consultation.
IRS CIRCULAR 230 NOTICE: To the extent that this message concerns tax matters, unless expressly stated otherwise, it is not intended to be used and cannot be used by the reader for the purpose of avoiding tax penalties that may be imposed by law. For more information about this notice, see http://www.irs.gov/pub/irs-utl/pcir230.pdf