What Is a Specified Employee Under Section 409A?

Internal Revenue Code (IRC) Section 409A establishes rules for nonqualified deferred compensation plans, which are arrangements that postpone an employee’s receipt of compensation to a future year. These regulations were introduced as part of the American Jobs Creation Act of 2004 and impact many payment structures, including some severance agreements and bonus plans. A component of Section 409A is the “specified employee” rule, which affects publicly traded companies and their highest-ranking individuals. This rule is designed to prevent insiders from accelerating their deferred compensation payments shortly before a company’s financial decline.

Determining if a Company is Subject to the Rule

The specified employee rule under Section 409A applies only to corporations with publicly traded stock. It does not extend to privately held companies, partnerships, or S-corporations whose stock is not on a public market. The distinction is based on the entity’s structure and public trading status, not its size or compensation amounts.

A public company is any corporation with stock traded on an “established securities market.” This includes major U.S. exchanges like the New York Stock Exchange or Nasdaq, as well as recognized foreign stock exchanges supervised by a governmental authority. U.S. taxpayers working for such foreign entities can be subject to these rules.

The rule also applies to subsidiary corporations or other affiliated entities within a controlled group. If a parent corporation’s stock is publicly traded, its 80%-owned subsidiaries are also subject to the specified employee rules. This ensures the regulation captures entities connected to a public corporation.

Identifying a Specified Employee

A “specified employee” is defined by referencing the “key employee” definition found in IRC Section 416, which is used for top-heavy plan testing. The process of identifying these individuals is mechanical and relies on objective tests related to ownership and compensation, rather than an employee’s title or duties. Public companies must conduct this analysis annually to create a definitive list of employees subject to the rule.

The first test is the 5% owner test, which identifies any employee who owns more than 5% of the company’s stock. The second is the 1% owner test, which applies to any employee who owns more than 1% of the stock and has annual compensation exceeding $150,000. This compensation threshold is not indexed for inflation.

The third test is for officers. This identifies the 50 most highly compensated officers of the company whose annual compensation exceeds an indexed threshold. For the 2025 effective period, this compensation threshold is $230,000. If the company has fewer than 50 officers, then only those individuals are considered for this test.

Companies use a “specified employee identification date,” which is December 31 by default. The list of specified employees is created based on data from the 12-month period ending on that date. This list becomes active on the “specified employee effective date,” which is April 1 of the following year, and is effective for 12 months. An employee on this list who separates from service during that period is subject to the payment delay.

The Six-Month Payment Delay Rule

The main consequence of being a specified employee is a mandatory six-month delay on certain deferred compensation payments. Any payment triggered by a “separation from service” cannot be paid until six months after the employee’s departure. This rule must be written into the nonqualified deferred compensation plan documents.

During this six-month waiting period, any payments that would have otherwise been made are accumulated. On the first business day following the end of the six-month period, the total accumulated amount is paid to the former employee in a single lump sum. For plans with installment payments, the plan can either delay the start of the series for six months or hold the first six months of installments for distribution after the delay period ends.

This delay only applies to payments made due to a separation from service. If a deferred compensation payment is scheduled for a different permissible event under Section 409A, the six-month delay does not apply. For example, a payment triggered by a change in control, a fixed date, or an unforeseeable emergency can be paid without the hold.

The employer is responsible for enforcing this rule. If the employer fails to delay a payment, the employee faces significant tax consequences, including immediate income inclusion of all deferred amounts, a 20% excise tax, and penalty interest.

Exceptions to the Six-Month Delay

There are specific exceptions where a payment can be made to a specified employee without the waiting period.

• Payments made on account of the employee’s death. If a specified employee dies after separating from service but during the six-month delay period, any deferred compensation can be paid to their beneficiaries without waiting for the period to conclude.
• Payments made due to an employee’s disability that meets the strict definition under Section 409A. This means the individual is unable to engage in any substantial gainful activity due to a medically determinable physical or mental impairment expected to last at least 12 months.
• A series of life annuity or other installment payments that began before the employee’s separation from service. The pre-existing payment schedule is allowed to continue uninterrupted.
• Payments exempt from Section 409A, such as those qualifying for the “short-term deferral” exception. This applies to compensation paid by the 15th day of the third month following the end of the year in which it vested.