Overview of Section 409A
“Why should I worry about 409A? I don’t have a deferred compensation plan.” We often get some version of this question and comment when discussing compensation and benefits-related issues. While “worry” might, admittedly, be a bit dramatic, the flippant response is sometimes a variant of “because 409A can impose an additional 20% income tax...sucker.” But, that doesn’t really answer the question; it might just grab someone’s attention.
Why consider Section 409A? So, why should someone be thinking about (or, every once in a while, worried about) Section 409A? For starters, its application extends well beyond the common sense idea of a deferred compensation plan. And, if a compensation or benefits arrangement is subject to Section 409A, and fails to comply with its rules and regulations, the individual entitled to the compensation or benefits is subject to an additional 20% income tax plus potential interest tax penalties.
PRACTICE POINT: SECTION 409A IS POTENTIALLY BROAD IN SCOPE AND, IF IT APPLIES, FAILURE TO COMPLY RESULTS IN AN ADDITIONAL 20% INCOME TAX PLUS POTENTIAL INTEREST TAX PENALTIES.
At first glance, someone reading Section 409A might quickly conclude that there is no reason to be concerned because the reader is not dealing with “deferred compensation” or a “nonqualified deferred compensation plan.” But, that might be a mistake because the definitions of those terms are actually quite broad. Under the Treasury Regulations, a “nonqualified deferred compensation plan” is “any plan … that provides for the deferral of compensation…” and, a “deferral of compensation” exists if a “service provider has a legally binding right during a taxable year to compensation that … is or may be payable … in a later taxable year.”
PRACTICE POINT: DEFERRED COMPENSATION CAN EXIST WHENEVER THERE IS A LEGALLY BINDING RIGHT ARISING IN ONE YEAR TO COMPENSATION IN A FUTURE YEAR.
Under those two general definitions, the potential universe of “deferred compensation” and “nonqualified deferred compensation plans” is enormous – annual cash bonus plans, equity incentive plans, tax-qualified retirement plans (e.g., 401(k) plans), severance arrangements, retention/stay bonuses, stock repurchase agreements where the company agrees to repurchase shares at an above market value, taxable fringe benefits and perks, and on and on. Luckily, there are clear exceptions to the general rules that move some of these arrangements, for example, tax-qualified retirement plans, outside the scope of Section 409A. In addition, exceptions exist for certain severance arrangements and equity incentive plans, provided they are structured in accordance with the requirements of the Treasury Regulations.
Common alternatives for addressing deferred compensation. If there is a possibility that a right to “deferred compensation” could exist under a “nonqualified deferred compensation plan,” there are two primary alternatives for addressing Section 409A:
- Determine if an exemption from, or an exception to, Section 409A is applicable; or
- Comply with the rules and regulations under Section 409A.
Other than the very specific exemptions excluding from Section 409A certain types of plans (e.g., tax-qualified retirement plans, employee stock purchase plans, bona fide vacation and sick leave plans, etc.), the most common exemption from Section 409A is for “short-term deferrals.” In general, the Treasury Regulations provide that there is no deferral of compensation where a deferred payment is actually or constructively received by the service provider within two and a half months following the end of the year in which a right to a payment is no longer subject to a substantial risk of forfeiture (i.e., after the right “vests”). This exemption is regularly relied upon to keep annual cash bonus plans, certain severance arrangements, and restricted stock units (a particular form of equity incentive award) outside of Section 409A.
On the other hand, to be compliant with Section 409A, a plan must be designed to satisfy the deferral election timing rules (where elective deferrals are permitted) and the distribution rules. Section 409A provides for only six permitted payment events (which must, generally, be established at the time of initial deferral):
- A service provider’s “separation from service” (in other words, a termination of employment);
- A service provider’s disability;
- A service provider’s death;
- A specified date or schedule;
- Certain change in control transactions (but, importantly, not an initial public offering); and
- Certain unforeseeable emergencies.
All these events (except death) are given more specific requirements under the Treasury Regulations.
Context for considering Section 409A matters. This is just the beginning of the analysis, and with changing facts and circumstances, there are many, many permutations. Also, in practice, while we do work with clients on the design and implementation of various types of compensation and benefits plans and arrangements, we’re sometimes being consulted after the fact, or in connection with diligence during an M&A transaction, and the “facts on the ground” are not always clear and straightforward. So, sometimes, we try to analyze and apply arguments to support what has already been done.
Explore the Compensation & Benefits Resource Library. We invite you to explore the rest of our Compensation & Benefits Resource Library to get a better idea of how some of the specific rules apply. Feel free to reach out with questions.
