What Is the 409A Change in Control Definition?

Section 409A of the Internal Revenue Code establishes rules for nonqualified deferred compensation plans, which are arrangements that postpone an employee’s receipt of compensation to a future year. These regulations dictate when and how deferred funds can be paid out. Failure to comply results in significant tax penalties for the employee, including immediate income inclusion of all deferred amounts, a 20% additional tax, and an interest penalty. One of the few permissible events that can trigger a payment is a “change in control.”

The definition of a change in control under Section 409A is highly technical and differs from definitions used in other contexts. Understanding this definition is a practical necessity for companies and executives to ensure that payments tied to corporate transactions are compliant. An improperly defined event in a plan document can lead to severe, unintended tax consequences.

The Three Types of 409A Change in Control Events

Section 409A provides three distinct, objectively determinable events that can qualify as a change in control. These definitions set minimum thresholds that a deferred compensation plan must use if it intends to make payments upon such an event. The regulations are precise, aiming to prevent manipulation of payment timing by either the employer or the employee.

Change in the Ownership of a Corporation

The first type of event is a change in the ownership of a corporation. This occurs when any one person, or more than one person acting as a group, acquires ownership of stock that, combined with any stock already owned, constitutes more than 50% of the total fair market value or total voting power of the corporation’s stock.

The concept of “persons acting as a group” is an important element. Individuals will not be considered a group simply because they buy stock at the same time. However, they are treated as a group if they are owners of a corporation that enters into a merger, consolidation, or similar business transaction with the target corporation. To determine stock ownership, the attribution rules under Internal Revenue Code Section 318 apply.

Furthermore, stock underlying a vested option is considered owned by the option holder for this test. This means the calculation must account for not just directly owned shares but also shares that could be acquired through vested equity awards.

Change in Effective Control of a Corporation

A change in effective control can be triggered in one of two ways. The first trigger is the acquisition of a significant block of voting power. This happens if any one person, or persons acting as a group, acquires 30% or more of the total voting power of the corporation’s stock within a 12-month period.

The second trigger involves a shift in the composition of the company’s board of directors. A change in control is deemed to occur if a majority of the members of the corporation’s board is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the board members prior to the date of the appointment.

Change in the Ownership of a Substantial Portion of a Corporation’s Assets

The final type of event is a change in the ownership of a substantial portion of a corporation’s assets. This test is met if a person or group acquires assets from the corporation that have a total gross fair market value equal to 40% or more of the total gross fair market value of all the corporation’s assets. This must occur within a 12-month period, and the sale must be to a person unrelated to the selling corporation.

“Total gross asset value” refers to the value of the assets without regard to any liabilities associated with them. The transaction must be a sale of assets, meaning transfers to a related person, such as a subsidiary or a major shareholder, do not count toward this threshold. This provision ensures that a transaction that fundamentally alters the corporation’s operating identity through the disposition of a large part of its business is recognized as a change in control.

Application to Corporate Transactions

The technical definitions of a 409A change in control have direct implications for common corporate transactions, and the specific structure of a deal determines which test is met. A standard merger or acquisition frequently triggers a change in control. In a cash buyout or a stock-for-stock merger, the transaction often results in a single person or group acquiring more than 50% of the target company’s stock, satisfying the “change in ownership” test.

Similarly, a leveraged buyout led by a private equity firm often meets the “change in effective control” test. This is because the firm and its co-investors will acquire a significant block of voting stock and usually replace a majority of the board of directors. An asset sale can also constitute a change in control if it is substantial enough, such as the sale of a major division that meets the 40% asset test.

Conversely, not all major corporate events qualify. An initial public offering (IPO) is a notable example of a transaction that is not a 409A change in control. During an IPO, ownership becomes more dispersed among the public rather than being consolidated in the hands of a new person or group. As a result, an IPO fails to meet the ownership or effective control thresholds.

Plan Document Specification and Permissible Modifications

The implementation of a change in control provision within a nonqualified deferred compensation plan is governed by strict documentation requirements. The plan document itself must specify the exact definition of the change in control event that will trigger a payment. This definition must be established at the time the deferral is made and cannot be added or changed retroactively.

Employers have a degree of flexibility in designing these provisions. A plan is not required to include all three types of 409A change in control events as payment triggers. For example, a company could draft its plan to permit distributions only upon a “change in ownership” while excluding payments upon a “change in effective control” or an “asset sale.”

While employers can choose which events to include, they have limited ability to alter the definitions. A plan can make the definition of a change in control more restrictive than the statutory minimums, such as requiring a 60% change in ownership to trigger a payment. However, a plan can never use a less restrictive definition, as this would constitute an impermissible acceleration of payment.

The scope of the change in control provision can also be tailored. In a large corporate group, an employer can designate whether a transaction at the ultimate parent company level will trigger payments for subsidiary employees, or limit the trigger to a sale of the specific subsidiary. This must be specified in writing in the plan document from the outset.