What Is a 409A Plan and How Does It Work?

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation arrangements. Its purpose is to ensure that compensation earned in one year but received in a future year is taxed appropriately. Compliance with these regulations helps prevent the manipulation of income timing for tax advantages.

The Framework of Nonqualified Deferred Compensation

Nonqualified deferred compensation (NQDC) refers to arrangements where an employee earns compensation in one year, but payment is delayed until a future year. Unlike qualified plans, such as 401(k)s, NQDC plans are not subject to the extensive requirements of the Employee Retirement Income Security Act (ERISA). This allows for greater flexibility in design and participation.

NQDC arrangements commonly involve various forms of compensation, including salary deferrals, bonuses, and equity awards like stock options or restricted stock units. These plans are typically offered to executives and highly compensated employees, providing them with an additional means to save beyond the contribution limits of traditional retirement plans.

The tax deferral benefit means employees do not pay income tax on these deferred amounts until received, allowing funds to grow on a tax-deferred basis. However, federal payroll taxes may apply when the employee’s right to the compensation becomes nonforfeitable, even if not yet paid.

Core Compliance Rules

To maintain the tax-deferred status of nonqualified deferred compensation, plans must adhere to specific rules outlined in IRC Section 409A. A fundamental requirement is a written plan document that clearly specifies the terms of deferral and distribution.

A significant rule concerns the timing of deferral elections. Generally, an election to defer compensation must be made irrevocably by the end of the calendar year preceding the year in which the services related to that compensation are performed. For newly eligible participants, an initial deferral election may be made within 30 days of becoming eligible, provided the election only applies to compensation earned after the election becomes irrevocable.

Section 409A also includes an “anti-acceleration” rule, which prohibits the acceleration of deferred compensation payments once they have been deferred. This means that once a payment schedule is established, it generally cannot be changed to an earlier date.

The concept of a “substantial risk of forfeiture” also plays a role in 409A compliance. Compensation is considered subject to a substantial risk of forfeiture if the right to the compensation is contingent upon the performance of substantial future services or the occurrence of a condition related to the purpose of the compensation. Once this risk lapses, the compensation is considered vested for 409A purposes, even if not yet paid.

Rules for Payouts

Nonqualified deferred compensation plans compliant with Section 409A permit distributions only upon the occurrence of specific, limited events. These events must be predetermined and explicitly stated in the plan document at the time the deferral election is made. Employees typically cannot choose when to receive their deferred compensation outside of these predefined triggers.

One permissible distribution event is separation from service. This occurs when an employee’s employment with the company ends. For certain highly compensated individuals known as “specified employees” of publicly traded companies, payments upon separation from service must be delayed for an additional six months following the separation date, or until death if earlier.

Payments can also be scheduled for a specified time or according to a fixed schedule. The plan must clearly define these payment dates or schedules at the time of the initial deferral. Another allowable trigger is a change in control of the corporation, which refers to a change in ownership, effective control, or ownership of a substantial portion of the company’s assets, as defined by Treasury Regulations.

The occurrence of death is also a permitted distribution event, allowing for payments to beneficiaries. Disability is another trigger, defined as an inability to engage in any substantial gainful activity due to a medically determinable physical or mental impairment expected to result in death or last for at least 12 months.

Finally, an unforeseeable emergency allows for distributions. This typically means a severe financial hardship resulting from an illness or accident of the service provider or their family, loss of property due to casualty, or other similar extraordinary circumstances beyond the service provider’s control. The amount distributed must be limited to what is reasonably necessary to satisfy the emergency need, including taxes, after considering other available resources.

Valuation Considerations for Equity

For private companies, Section 409A has particular relevance for equity-based compensation, such as stock options. To avoid immediate taxation of these awards, the exercise price of a stock option or the grant price of other equity must be set at or above the fair market value (FMV) of the underlying stock on the grant date. This requirement ensures that the equity is not granted at a discounted price that could be considered deferred compensation.

A “409A valuation,” also known as a 409A appraisal, is an independent assessment performed to determine the fair market value of a private company’s common stock for tax purposes. Since private company stock is not publicly traded, an independent valuation is necessary to establish this value. This valuation helps companies set a defensible strike price for equity awards.

The IRS provides “safe harbor” methods for establishing this fair market value, which, if followed, create a presumption of reasonableness for the valuation. These methods include obtaining an independent appraisal from a qualified third party, utilizing a formula-based valuation, or, for illiquid startup companies, meeting specific criteria. Obtaining a 409A valuation helps protect both the company and employees from potential tax penalties.