Internal Revenue Code section 409A
Section 409A of the Internal Revenue Code regulates the treatment for federal income tax purposes in the United States of nonqualified deferred compensation paid by a "service recipient" to a "service provider". Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, as well as entities that provide services (an LLC, for example, could be a service provider).
Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine.
Section 409A generally provides that a “nonqualified deferred compensation plan” must comply with various rules regarding the timing of deferrals and distributions. The penalty for non-compliance is severe in that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income.
Under regulations issued by the IRS, Section 409A applies whenever there is a “deferral of compensation,” which occurs whenever an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or death benefit plan. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.
Section 409A’s timing restrictions fall into three main categories:
1) restrictions on the timing of distributions;
2) restrictions against the acceleration of benefits; and
3) restrictions on the timing of deferral elections.
Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances:
1) the employee’s separation from service;
2) the employee's becoming disabled;
3) the employee's death;
4) a fixed time or schedule specified under the plan;
5) a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation; or
6) the occurrence of an unforeseeable emergency.
In addition, Section 409A provides that with respect to certain “key employees” of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier.) Key employees are generally the top 50 employees with pay above $150,000.
The rules restricting the timing of elections as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories:
(1) initial deferral elections; and
(2) subsequent deferral elections.
As a general rule, initial deferral elections must be made no later than the close of the employee's taxable year immediately preceding the service year. The term “initial deferral elections” includes all decisions, whether made by the employee or employer, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections.
- Stumpff, Andrew (November 2007). "Deferred Compensation and the Policy Limitations of the Nuclear Option". Falls Church, Virginia: Tax Analysts. Retrieved 2010-08-21.