What Is 409A Deferred Compensation?

Section 409A of the Internal Revenue Code governs non-qualified deferred compensation. Enacted to prevent indefinite tax postponement, it addresses income recognition timing. It applies to many compensation agreements beyond traditional retirement plans. Its regulations establish a framework for structuring and administering these arrangements. Adherence is important for employers and employees, as non-compliance leads to substantial tax penalties.

Understanding 409A Deferred Compensation

Non-qualified deferred compensation, under Section 409A, is compensation earned in one year but paid later. Unlike qualified plans (e.g., 401(k)s, pensions), non-qualified plans lack favorable tax treatment or ERISA protections. The term “plan” under 409A broadly includes formal written plans and any other deferred compensation arrangement.

Congress enacted Section 409A to ensure proper taxation of non-qualified deferred income, especially after corporate scandals. It prevents executives from controlling income timing, which could lead to indefinite tax deferral. This legislation aligns deferred compensation’s tax treatment with its economic reality, recognizing income when a legally binding right arises, unless specific conditions are met.

Section 409A’s scope is extensive, covering nearly any arrangement where an employee gains a legally binding right to compensation paid in a subsequent year. This broad reach means many compensation arrangements, even those not traditionally considered deferred compensation, can fall under 409A if payment is delayed. Examples include severance agreements, bonus plans, and equity awards deferring payment beyond a short period.

Several compensation arrangements are not considered 409A deferred compensation. Qualified employer plans (e.g., 401(k)s, pensions) are excluded due to their own rules and tax benefits. Welfare benefits, like bona fide vacation, sick leave, disability pay, and death benefit plans, also fall outside 409A’s purview.

The “short-term deferral” rule applies if compensation is paid quickly. If a payment is made by the 15th day of the third month following the tax year in which the right vests, it is exempt from 409A. Severance pay can also be exempt under limited conditions, such as involuntary termination or when the amount does not exceed statutory limits.

Key Compliance Requirements

Compliance with Section 409A requires adhering to structural and operational rules for non-qualified deferred compensation. These dictate how plans must be designed and administered to avoid severe tax penalties. Any 409A-subject deferred compensation arrangement must be in writing, specifying its terms and conditions.

Deferral election timing rules are strict. An election to defer compensation must be made by the end of the calendar year prior to the year services are performed. New hires have an exception, allowing election within 30 days of eligibility, covering only future services. Performance-based compensation has specific timing rules, allowing later elections under certain conditions.

Deferred compensation can only be paid out upon specific, permissible distribution events established at deferral election. These events include:
Separation from service
Death
Disability
A specified time or fixed schedule
A change in company control
An unforeseeable emergency

Each event’s definition is precise under 409A regulations, and payments must align for compliance. For instance, separation from service means a complete termination of the employment relationship, not just a change in duties.

Deferred compensation cannot be paid out earlier than the specified distribution event. Once a payment schedule is established, it cannot be changed to an earlier date. This rule prevents participants from manipulating income timing for immediate tax benefits. Limited exceptions exist, such as payments for domestic relations orders or employment taxes.

Rules exist for subsequent deferrals, changing the time or form of payment after the initial election. A subsequent deferral election must delay payment for at least five additional years from the original payment date. This election must be made at least 12 months before the original due date. For payments tied to a change in control, unforeseeable emergency, or disability, the subsequent election cannot be made less than 12 months before the first scheduled payment.

Taxation of 409A Plans

Taxation of deferred compensation under Section 409A depends on compliance. For compliant plans, income is not taxed until paid to the employee or made available, typically in a later tax year. This defers tax liability, allowing the employee to pay no income tax on deferred amounts, including earnings, until funds are received. This can be advantageous for individuals expecting a lower tax bracket in retirement or when compensation is paid.

A compliant non-qualified deferred compensation plan’s benefit is tax deferral, allowing deferred amounts to grow without current taxation. This differs from immediate taxation if compensation were paid directly in the year earned. Deferred amounts are unfunded and subject to the employer’s general creditors, distinguishing them from qualified plans where assets are held in a separate trust.

Non-compliance with Section 409A has severe consequences for the employee. If a deferred compensation arrangement fails to meet 409A requirements, all deferred amounts become immediately taxable to the employee in the year of violation, if not subject to substantial risk of forfeiture or previously included in gross income. This immediate inclusion means the employee pays taxes on money not yet received.

Beyond immediate taxation, non-compliance triggers additional penalties. A 20% penalty tax is imposed on the amount included in the employee’s gross income due to the violation. This penalty applies on top of the ordinary income tax rate. Interest is also assessed on underpayments that would have occurred had the deferred compensation been included in income when originally deferred or no longer subject to substantial risk of forfeiture. Interest accrues from the year compensation was earned or vested, compounding the financial burden.

These penalties apply to all participants in the non-compliant plan, not just the individual responsible. This broad applicability underscores the need for meticulous compliance in all deferred compensation arrangements. Even unintentional violations can lead to financial repercussions, making regular review and adherence to 409A rules crucial for compensation planning.

Common Deferred Compensation Arrangements Under 409A

Many compensation arrangements fall under Section 409A due to their deferred payment nature. Elective deferred compensation plans are common, allowing employees, often highly compensated, to defer salary, bonus, or other compensation until a future date, such as retirement. These plans provide executives flexibility to manage tax liability over time.

Supplemental Executive Retirement Plans (SERPs) are another common arrangement subject to 409A. These non-qualified plans provide additional retirement benefits to executives beyond qualified plan limits (e.g., 401(k)s). SERPs often promise a specific benefit or formula upon retirement, with payments deferred until after separation from service.

Long-Term Incentive Plans (LTIPs), cash- or equity-based, frequently involve deferred compensation and are subject to 409A. These plans vest over several years and pay out in the future, often tied to long-term performance goals. Examples include phantom stock, restricted stock units (RSUs) with deferral features, and performance units paying cash or equity after a multi-year performance cycle.

Certain severance plans can be subject to 409A if payments extend beyond the short-term deferral period or do not meet specific exceptions. Many severance arrangements are exempt if paid within a short timeframe after termination. However, those promising payments over an extended period or upon events other than involuntary termination may trigger 409A compliance. Careful drafting ensures compliance or exemption.

Stock options and stock appreciation rights (SARs) can also be subject to 409A, particularly if granted with an exercise price less than fair market value on the grant date, or if they include income deferral features. Properly valued stock options granted at or above fair market value are exempt from 409A. However, any discount at grant or a deferral feature can bring these equity awards into the regulations’ scope.