What Is Section 409A and How Does It Work?

Section 409A of the Internal Revenue Code (IRC) is a federal tax law regulating specific types of non-qualified deferred compensation arrangements. Enacted as part of the American Jobs Creation Act of 2004, its primary goal is to prevent tax avoidance. It ensures deferred compensation is taxed when legally earned, rather than solely when paid out. This framework imposes strict rules on how and when certain deferred compensation can be paid, aiming to align taxation with compensation vesting.

Understanding Section 409A

Non-qualified deferred compensation (NQDC) is an agreement between an employer and an employee to pay compensation in a future year, distinct from qualified plans like 401(k)s or IRAs. Unlike qualified plans, NQDC plans are not subject to the Employee Retirement Income Security Act of 1974 (ERISA) and do not receive the same tax benefits or protection from creditors. Section 409A applies when an employee has a legally binding right to compensation in one taxable year that may be paid in a later year.

Section 409A aims to prevent individuals from controlling the timing of income recognition for tax purposes. For example, it prevents executives from shifting income between tax years by choosing when to receive a bonus. While not prohibiting deferred compensation, which can be a valuable tool for talent retention, Section 409A establishes specific requirements for structuring and administering these arrangements to ensure proper tax treatment.

Types of Deferred Compensation Subject to Section 409A

Section 409A covers compensation arrangements where payment is deferred beyond the year the right to compensation arises. Common examples include:
Elective deferrals: Salary, bonuses, or commissions, allowing employees to postpone income.
Phantom stock plans: Grant employees a right to a cash payment equal to company share value, if deferred.
Stock appreciation rights (SARs): Awards providing a cash payment based on increased stock value, if not settled shortly after exercise or vesting.
Restricted stock units (RSUs): If an RSU vests but shares or cash are not delivered until a later, specified event, it constitutes a deferral.
Severance arrangements: Especially those providing extended or discretionary payments.
Certain stock options: Including “discounted options” granted below fair market value. Options with a floating exercise price or those based on a multi-day average can also be treated as deferred compensation. Dividend equivalents contingent upon option exercise might also be considered an exercise price reduction.

Compliance Requirements for Section 409A

Compliance with Section 409A involves adhering to strict requirements for structuring and administering deferred compensation plans.

Written Plan and Elections

Any non-qualified deferred compensation plan must be in writing and specify the amount, timing, and form of deferred compensation. Initial deferral elections generally must be made by the end of the tax year preceding the year services are performed. For performance-based compensation, elections can sometimes be made later, but still well in advance of payment.

Subsequent deferral elections, changing the payment date or form after an initial election, are subject to stringent rules. Such elections typically require a minimum five-year delay from the originally scheduled payment date and must be made at least 12 months before the original payment date.

Permissible Distribution Events

Section 409A limits the circumstances under which deferred compensation can be paid out. These permissible distribution events include:
Separation from service
A specified date or fixed schedule
Death
Disability
A change in control of the company
An unforeseeable emergency (e.g., severe financial hardship from illness or accident)

Prohibition on Acceleration and Funding

Payments cannot be made earlier than the specified distribution events. An exception exists for specified employees of publicly traded companies, where certain payments upon separation from service must be delayed by at least six months. This “six-month delay rule” applies to the top 50 highest-paid officers.

Section 409A also addresses funding limitations. Deferred compensation should not be funded in a way that protects the assets from the employer’s creditors. For example, using certain offshore trusts or assets set aside for deferred compensation can trigger immediate taxation if they become restricted due to a change in the employer’s financial health.

Consequences of Non-Compliance

Failing to comply with Section 409A can lead to severe tax penalties imposed directly on the individual employee, not the employer.

Immediate Taxation and Penalties

All deferred amounts under the non-compliant plan become immediately taxable in the year the violation occurs, even if the compensation has not yet been paid.

An extra 20% penalty tax is imposed on the non-compliant deferred amount. For example, a $100,000 non-compliant amount incurs an additional $20,000 penalty tax.

An interest penalty is also assessed, calculated at the underpayment rate plus 1% from the year the compensation was originally deferred or vested. This interest accrues from the date the compensation should have been included in gross income.

Employer Reporting

Employers also have reporting obligations for non-compliant amounts. They must report these amounts on Form W-2 for employees or Form 1099 for independent contractors, indicating the taxable amount and penalties.

Valuation for Section 409A Purposes

Independent “409A valuations” are important for private companies that issue equity-based deferred compensation such as stock options or stock appreciation rights. Their primary purpose is to establish the fair market value (FMV) of the company’s common stock when equity awards are granted, ensuring stock options are granted with an exercise price equal to or greater than the FMV. Granting options below FMV can classify them as “discounted options,” which are non-compliant under Section 409A, leading to adverse tax consequences for the recipient.

Valuation Methodology

A 409A valuation involves analyzing the company’s financial condition, industry outlook, and economic environment. Appraisers require financial statements, capitalization tables, business plans, and industry data. Various valuation approaches may be employed, including:
The income approach (e.g., discounted cash flow)
The market approach (e.g., comparable company analysis)
The asset approach

The approach chosen depends on the company’s development stage and available data.

Safe Harbor and Compliance Impact

Using qualified independent appraisers is recommended for 409A valuations. The IRS provides a “safe harbor” presumption of reasonableness if the valuation is performed by a qualified appraiser using generally accepted valuation methods. This safe harbor means the IRS generally presumes the valuation is correct unless a gross error is shown. Without this, the burden of proof for FMV rests with the company and award recipient.

The valuation directly impacts compliance for equity awards by setting the baseline for the exercise price of options or the strike price of SARs. Inaccurate FMV or awards granted below this value risk violating Section 409A.