What Are the 409A Final Regulations?

Section 409A of the Internal Revenue Code is a set of rules governing nonqualified deferred compensation (NQDC). It was enacted to address arrangements that gave service providers significant control over the timing of their compensation, and its primary function is to eliminate that control. The regulations establish requirements for when compensation can be deferred, when it can be paid, and how these terms must be documented.

These rules apply to many payment arrangements that may not be intuitively recognized as deferred compensation. Failure to comply with the regulations can trigger substantial tax penalties for the individual service provider, making adherence a matter of financial importance.

Scope of Section 409A

Section 409A applies to any arrangement that provides for a “deferral of compensation.” This occurs when a service provider, like an employee or independent contractor, gains a legally binding right in one taxable year to compensation that may be paid in a future taxable year. A legally binding right exists even if the amount is subject to vesting, as long as the employer cannot unilaterally reduce or eliminate it after services are rendered.

This definition covers many common compensation plans. Examples include Supplemental Executive Retirement Plans (SERPs), which provide benefits above qualified plan limits, and plans allowing elective deferrals of salary or bonuses. Other arrangements include phantom stock plans, which grant cash awards based on company stock value, and stock appreciation rights (SARs) with features like a discounted exercise price.

The primary exemption is the “short-term deferral” rule, which applies if a payment is made by the 15th day of the third month after the end of the taxable year in which the right to the payment becomes substantially vested. For most, this deadline is March 15. Substantial vesting occurs when an employee is no longer required to perform future services to receive the payment. For example, a bonus for the 2025 calendar year that vests on December 31, 2025, avoids being deferred compensation if it is paid by March 15, 2026.

Other types of compensation are also excluded from Section 409A. These include qualified retirement plans like 401(k)s and defined benefit pension plans. Certain separation pay plans can also be exempt if they meet specific criteria regarding the reason for termination and the payment amount.

Core Deferral and Distribution Rules

The regulations under Section 409A impose a disciplined framework on the timing of deferral decisions and subsequent payments. These rules are designed to remove discretion from the service provider once a deferral is in place, ensuring the timing of income recognition cannot be manipulated.

Initial Deferral Elections

An election to defer compensation must be made in writing before the start of the calendar year in which the services are performed. For example, an election to defer a salary to be earned in 2026 must be finalized by December 31, 2025. This prevents individuals from making deferral decisions based on their financial situation during the year.

There are exceptions to this rule. An employee new to a deferred compensation plan can make an election within 30 days of becoming eligible, but it only applies to compensation for services performed after the election. For performance-based compensation, defined as pay contingent on satisfying criteria over at least 12 months, the election can be made up to six months before the end of the performance period.

Permissible Payment Timing

Once deferred, compensation can only be paid upon one of six specified events, which must be designated when the deferral is made. A plan cannot allow payment for other reasons, such as a child’s college enrollment or a home purchase. The permissible payment triggers are:

• Separation from service
• Disability
• Death
• A specified time or fixed schedule
• A change in control event
• An unforeseeable emergency

For “specified employees” of public companies, who are among the top 50 most highly compensated officers, payments due to separation from service must be delayed for at least six months. The definitions for disability and unforeseeable emergency are also restrictive. A disability must be a medically determinable impairment expected to result in death or last for at least 12 months, while an unforeseeable emergency is a severe financial hardship from specific events like an illness or accident.

Prohibition on Acceleration

Section 409A prohibits the acceleration of payment timing. Once the time and form of payment are set, they cannot be changed to make the payment earlier. This rule prevents both the company and the employee from agreeing to an early payout.

The regulations provide few exceptions to this anti-acceleration rule. A plan may allow an accelerated payment to cover FICA taxes due when an amount vests. Another exception allows for the cash-out of small balances, such as those below the annual 401(k) contribution limit.

Plan Document and Operational Requirements

Section 409A compliance requires both a compliant plan document and operating that plan according to its terms. A failure in either area can lead to tax consequences.

Documentary Compliance

Every NQDC arrangement must have a written plan document that details the core terms of the deferral. It must specify the amount of compensation being deferred or provide a formula for determining it. Oral agreements are insufficient and constitute a documentary failure.

The plan document must also define the timing and form of payment. It must state which of the six permissible events will trigger payment and in what form, such as a lump sum or installments. The document cannot grant the employee discretion to change the payment time or form after the initial deferral election.

Operational Compliance

A service recipient must administer the plan in strict accordance with its written terms. An operational failure occurs when the plan’s administration deviates from the document. Even with a compliant document, an execution error can trigger a Section 409A violation.

A common operational failure is making a payment at a time not permitted by the plan. For example, if a company grants an employee’s request for an early distribution for a reason that does not qualify as an unforeseeable emergency under the plan’s terms, an operational failure has occurred.

Consequences of Noncompliance

Failure to comply with Section 409A results in immediate tax penalties for the service provider, not the employer. The “plan aggregation” rule can expand the impact of a single error. Under this rule, all deferred compensation plans of a similar type are grouped together, so a failure in one arrangement can cause all similar plans to fail.

When a violation occurs, three tax consequences are triggered for the employee in the year of the failure:

• All vested amounts under the failed plan and aggregated plans are immediately included in the employee’s gross income for that year. This applies even if the money has not been paid, meaning an employee must pay tax on compensation they may not receive for years.
• An additional federal penalty tax of 20% is imposed on the amount included in income.
• A premium interest tax is assessed on the underpayment of taxes that would have occurred if the compensation had been included in income when it originally vested.

For example, if an employee has a $500,000 vested balance in a noncompliant plan, the entire amount becomes subject to ordinary income tax in the year of the failure. An additional tax of $100,000 (20% of $500,000) is also due, along with premium interest calculated retroactively.

Official Correction Programs

The IRS established formal correction programs that provide a way for companies to fix certain errors and potentially mitigate the tax consequences for employees. The ability to use these programs depends on the nature of the error, when it is discovered, and how quickly it is corrected.

The relief available often depends on whether the error is documentary or operational, how long it has existed, and whether the employee is an insider. For some operational errors, if corrected within a limited timeframe, penalties can be reduced. This might involve the employee repaying an amount that was paid out too early.

For documentary failures, the program may require the plan language to be amended to comply with Section 409A before the end of the year the error is found. The availability and terms of relief are complex, and not all errors are eligible for correction. These programs have their own requirements and deadlines, making it important to seek guidance from experienced counsel upon discovering a potential violation.