Applying Section 409A’s “6-Month Delay Rule”

Section 409A includes a rule informally referred to as the “6-Month Delay Rule” that prohibits the payment of deferred compensation owed to a “specified employee” due to a “separation from service” until six months after the date that the specified employee separates from service (or, if earlier, the date of the specified employee’s death).[1] If the 6-Month Delay Rule is not followed, the specified employee’s entire benefit under the particular arrangement (and any aggregated arrangements) are included in income and subject to an additional 20% income tax plus premium interest. 

PRACTICE POINT: THE 6-MONTH DELAY RULE IS MANDATORY WHERE A SPECIFIED EMPLOYEE IS RECEIVING A DISTRIBUTION OF DEFERRED COMPENSATION SUBJECT TO SECTION 409A IN CONNECTION WITH A SEPARATION FROM SERVICE.

We’ve summarized below some of the key concepts related to the determination of “specified employees” under Section 409A.

1. Is the service recipient covered by the 6-Month Delay Rule?

Only employees of a service recipient (e.g., an employer) whose stock is traded on an “established securities market” may become specified employees that are subject to the 6-Month Delay Rule.  Included with such service recipient are any subsidiaries or affiliates in the same “controlled group” as such service recipient which is generally determined under Section 414.

Most commonly, but not exclusively, a “controlled group” will be made up of a parent company and any subsidiaries or affiliates that are at least 80% owned (directly or indirectly) by the parent company. Importantly, there are other ways an entity can be “pulled into” a controlled group, but an exhaustive discussion of the controlled group rules is beyond the scope of this overview.

An “established securities market” includes national (e.g., NYSE and NASDAQ) and foreign national securities exchanges supervised by a governmental authority, as well as over-the-counter markets reflected by an interdealer quotation system (e.g., “pink sheets”).

As such, even entities not typically thought of as “publicly traded” can be covered by the 6-Month Delay Rule.

2. Which employees are specified employees?

Once it is established that the service recipient is covered by the 6-Month Delay Rule, the service recipient should determine which of its employees may be “specified employees.” An employee is a specified employee if, on the date of his or her separation from service, he or she is a “key employee,” as defined under Section 416(i) as follows:

• any officer with annual compensation greater than the indexed threshold amount of $230,000 (for 2025);
• a 5% owner of the employer; or
• a 1% owner of the employer with annual compensation greater than $150,000 (not indexed for inflation).

Definition of “officer.” For purposes of determining the number of officers that are specified employees based on their compensation, generally, no more than 50 employees (or, if lesser, the greater of three or 10% of the employees) shall be treated as officers.  Such determination is made on a controlled group basis with exclusions for certain part-time, short-tenure, collectively bargained, and other similar categories of employees. Officers who are specified employees through their stock ownership are excluded for purposes of determining the officers who are classified as specified employees based on their compensation.

PRACTICE POINT: IF THE SERVICE RECIPIENT (CONTROLLED GROUP) HAS FEWER THAN 491 EMPLOYEES, THE MAXIMUM NUMBER OF OFFICERS IS LIMITED TO THE GREATER OF 10% OF EMPLOYEES (ROUNDED UP) OR THREE EMPLOYEES.

The determination of whether an employee is an “officer” should be made after considering all the facts and circumstances, and is made by reference to the employee’s authority, the term for which the employee is elected or appointed, and the nature and extent of the employee’s duties. An employee such as a vice president, director, or manager who does not have an officer title (e.g., chief operating officer) may still be an officer for specified employee purposes. Similarly, an employee who holds an officer title may not be an officer under the specified employee rules. Note, in particular, that an “officer” under Section 409A differs from the securities law definitions of “officer” and “executive officer.” 

Definition of “compensation.” Section 409A provides specific rules regarding the definition of “compensation” for purposes of determining specified employees, but the rules provide employers some flexibility to use alternative definitions of compensation, so long as the chosen alternative definition is used for all of the employer’s deferred compensation plans.  For example, many employers will use an alternative definition of compensation provided under Section 409A, such as Box 1 W-2 compensation, adding back in amounts excluded from income under a cafeteria plan, qualified transportation fringe benefit plan, or tax-qualified retirement plan (e.g., 401(k) plan).  

Note also, Section 409A includes specific rules as to how an employer may determine which employees are specified employees following a corporate transaction (e.g., merger of public and private companies, spinoff, public offering, and other corporate transactions).

3. During what period is an employee considered a specified employee?

Section 409A provides that an employee who meets the requirements to be a specified employee at any time during the 12-month period ending on the “specified employee identification date” is treated as a specified employee for the entire 12-month period beginning on the “specified employee effective date.”

Under Section 409A the default specified employee identification date is December 31. The default specified employee effective date is the first day of the fourth month following the identification date. Accordingly, for an employer that uses the default identification date of December 31, the default effective date is the following April 1. An employer may elect an alternative identification date and/or effective date, subject to specific limitations; but, the same identification and effective dates must be used for all of the employer’s deferred compensation plans.  

PRACTICE POINT: MOST EMPLOYERS USE THE “DEFAULTS” FOR DETERMINING SPECIFIED EMPLOYEES. THAT MEANS, THEY USE COMPENSATION FROM THE IMMEDIATELY PRIOR CALENDAR YEAR TO DETERMINE THEIR SPECIFIED EMPLOYEES FOR THE PERIOD FROM APRIL 1 – MARCH 31. THEY TYPICALLY MAKE THESE DETERMINATIONS DURING JANUARY – MARCH OF EACH CALENDAR YEAR.

Employers are responsible for determining the specified employees for each 12-month period. If an employee is determined to be a specified employee for an applicable 12-month period and separates from service, the employee is subject to the 6-Month Delay Rule.

4. Should the specified employee determination process be documented?

Employers are not bound by the “default” rules noted above and have some flexibility in designing their approach to applying the 6-Month Delay Rule as long as they are consistent in applying their approach. Regardless of whether an employer chooses to use the general rule or an alternative method for determining its specified employees, for administrative tracking purposes, we recommend documenting the specified employee determination process. In particular, we recommend that employers establish a “specified employee policy,” setting forth how the employer determines its specified employees and maintaining a spreadsheet that reflects the employees determined to be specified employees, reason for determination, and dates for which the employee is a specified employee. In lieu of a specified employee policy, the employer’s board of directors, compensation committee, or other applicable governing body may wish to adopt resolutions specifying the criteria for determining specified employees. If decisions regarding the specified employee determination process are not documented appropriately, the employer would be required to use the “default” rules set forth under Section 409A.

5. Can an error in applying the 6-Month Delay Rule be corrected?

The Internal Revenue Service has established correction procedures both for payments made in violation of the 6-Month Delay Rule and for documents that should, but do not, contain the 6-Month Delay Rule. The particular corrections are facts and circumstances specific but may provide avenues to avoid incurring the full extent of the income inclusion, additional income tax, and premium interest penalties referenced above.        

[1] Visit our Compensation & Benefits Resource Library for more information on the definition of “separation from service,” which is nuanced under Section 409A.