Understanding Section 409A’s Short-Term Deferral Exception

While Section 409A generally applies to compensation that is earned in one taxable year but paid in a later taxable year, not all such compensation is treated as “deferred compensation” subject to Section 409A’s requirements. One important exception is the “short-term deferral” exception, which allows certain compensation to avoid the application of Section 409A altogether, provided that the applicable compensation is paid within a limited period following the time in which the employee obtains a legal right to the compensation (i.e., the date in which the compensation is “vested” or “earned”).

PRACTICE POINT: PROPERLY STRUCTURED “SHORT-TERM DEFERRALS” ARE NOT SUBJECT TO THE VAST MAJORITY OF RULES UNDER SECTION 409A.

The following Q&A summarizes some of the most important aspects of the short-term deferral exception.

1. What is the short-term deferral exception?

The short-term deferral exception generally provides that compensation is not considered “deferred” (and therefore is not subject to Section 409A) if it is paid no later than the 15th day of the third month following the end of the employer’s (or employee’s, if later) taxable year in which the right to the payment is no longer subject to a “substantial risk of forfeiture.”

For example, for an employer with a January 1 – December 31 tax year, if an employee earned their bonus by remaining employed through December 31, 2025, even if the attainment of the bonus’ performance goals is calculated in the first quarter of 2026, this means that the bonus is no longer subject to a substantial risk of forfeiture in 2025 and would need to be paid by March 15, 2026 to qualify as a short-term deferral.

2. What is a “substantial risk of forfeiture”?

A “substantial risk of forfeiture” exists when the employee’s right to the compensation is conditioned on the performance of future services or the occurrence of a condition related to the purpose of the compensation (e.g., achievement of performance goals) and there is a meaningful possibility that the condition will not be satisfied. In the example above, the substantial risk of forfeiture is the requirement that the employee remain employed through December 31 to earn a bonus. Once the substantial risk of forfeiture lapses, either because the service requirement is satisfied or the applicable condition is met, the short-term deferral period begins to run.

PRACTICE POINT: ONE REASON FOR REQUIRING CONTINUED SERVICE THROUGH THE PAYMENT DATE OF AN ANNUAL BONUS (INSTEAD OF DECEMBER 31 OF THE YEAR FOR WHICH EARNED) IS TO ENSURE “SHORT-TERM DEFERRAL” TREATMENT UNDER SECTION 409A.

3. Can a payment still qualify as a short-term deferral if it is delayed beyond the short-term deferral window?

Yes. Section 409A allows limited administrative delays without disqualifying the payment from the short-term deferral exception, including:

• In certain instances where it is administratively impracticable to make the payment within the short-term deferral window and such impracticability was not foreseeable as of the date that the employee first had a legally binding right to the compensation.
• When a payment becomes subject to the deduction limit under Section 162(m) if paid within the short-term deferral window in instances where the employer would not have reasonably anticipated the deduction limit under Section 162(m) to apply to such payment at the time the employee first had a legally binding right to the payment.
• If making the payment within the short-term deferral window would jeopardize the employer’s ability to continue as a going concern.

4. Are severance payments ever eligible for the short-term deferral exception?

Yes, but only if the employee’s right to the severance is conditioned on an involuntary termination, or a mutually agreed-upon termination, and the payment is made within the short-term deferral period following the termination. If the severance includes any portion that is payable later than the March 15 deadline, such portion would be subject to Section 409A.

Special care should be taken with installment severance payments, as the entire payment stream of installments may be subject to Section 409A if any portion is not paid within the short-term deferral period.

5. What happens if a payment fails to qualify for the short-term deferral exception?

If compensation does not qualify for the short-term deferral exception (and no other exception applies), the arrangement is subject to Section 409A. This means it must comply with Section 409A’s documentary and operational requirements, including rules on permissible payment events and timing, and any failure could result in:

• Immediate income inclusion for the employee;
• An additional 20% federal income tax; and
• Interest penalties on the deferred amount.

6. Is documentation required to rely on the short-term deferral exception?

While a plan or arrangement does not have to specifically reference the short-term deferral exception to qualify for it, it should include payment terms that unambiguously provide that the payment will be made in a manner that clearly meets the requirements of the short-term deferral rules (e.g., stating that payment will be made no later than March 15 of the following year or requiring continued service through the payment date). If the documentation is ambiguous or leaves open the possibility of payment after the short-term deferral deadline, the IRS may take the position that the arrangement is subject to Section 409A, even if the payment was actually made on time.

PRACTICE POINT: “SHORT-TERM DEFERRALS” DO NOT HAVE TO BE IN WRITING; BUT, IN ORDER TO AVOID FUTURE POTENTIAL ISSUES, IT IS RECOMMENDED THAT ALL SUCH ARRANGEMENTS BE IN WRITING.

Employers may also wish to maintain a spreadsheet that tracks arrangements that rely on the short-term deferral exception, particularly in the context of bonuses, equity awards, and severance arrangements.