Tax Code Section 409A regulates the treatment of nonqualified deferred compensation. Generally, it provides that deferred compensation arrangements which do not meet certain requirements regarding advance elections as to the deferral of income and the form and timing of distributions will be subject to severe penalties. Code Section 409A does not replace existing tax laws, but it has already produced far-reaching changes in executive compensation practices.
409A generally applies to any arrangement that results in the deferral of compensation to a service provider, unless it falls within an exemption. This includes both elective deferrals (such as salary or bonus deferrals) and nonelective deferrals by an employer.
Covered Service Providers
Employees and directors are service providers. Independent contractors are service providers unless they provide non-management services to two or more unrelated service recipients. The final regulations provide that an independent contractor must not receive more than 70 percent of his or her revenue from a single source to fall within a safe harbor for 409A exemption.
Deferral of Compensation
A deferral of compensation occurs when a service provider has a "legally binding right" to receive compensation during a later calendar year. A legally binding right means that the compensation has been earned, but does not require it to be vested.
Under the short-term deferral rule, a deferral of compensation does not occur if the payment is made no later than two and on-half months following the later of:
- the end of the service provider's (i.e, participant's) taxable year in which the compensation vests; and
- the end of the service recipient's (i.e., employer's) taxable year in which the compensation vests.
The short-term deferral exemption is extremely important because it exempts many common arrangements from 409A.
A severance plan is not subject to 409A if it falls within the short-term deferral exemption described above. Severanace payments triggered by involuntary separations from service are also exempt "to the extent" they (1) do not exceed two times the employee's base pay (in the year before separation) up to the Code Section 401(a)(17) compensation limit and (2) are completely paid by the end of the employee's second full taxable year following termination (i.e., by the end of the second taxable year of the employee following the year of the separation from service). (Note: If payments exceed the cap, only the payments above the cap are subject to 409A because of the "to the extent" language.)
In some cases a voluntary resignation will be deemed to be involuntary if caused by a material reduction in an employee's compensation or responsibilities, or by other factors described in the final regulations.
Restricted Stock Plans
Restricted stock plans are generally exempt unless they include a deferral feature.
Stock options and SARs
Stock options and SARs must have an exercise price of at least fair market value at the time of grant to avoid 409A penalties. An ISO and an employee stock purchase plan are exempt from 409A.
Fair Market Value
The fair market value of the stock may be determined based upon:
- the last sale before or the first sale after the grant,
- the closing price on the trading day before or the trading day of the grant,
- the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or
- any other reasonable method using actual transactions in such stock as reported by such market.
Fair market value also may be determined using an average selling price during a specified period that is within 30 days before or 30 days after the applicable valuation date, provided that the program under which the stock right is granted must irrevocably specify that fair market value will be determined this way before the beginning of the specified period.
Nontaxable amounts are not subject to 409A. This exemption means that medical plans are exempt from 409A unless they provide taxable benefits. Fully insured arrangements cannot be taxable to employees, but discriminatory self-insured plans may cause reimbursements to be taxable to HCEs (and thus subject to 409A). However, taxable medical reimbursements as part of a severance plan are not subject to 409A if the benefits do not last longer than the COBRA continuation period (typically 18 months).
409A does not apply to payments resulting from litigation or a bona fide settlement.
Generally, if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of 409A in design or operation, all amounts deferred under the plan by any participant with respect to whom the failure relates, are includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture (i.e., not vested) and not previously included in gross income.
If a deferred amount is required to be included in income under Section 409A, the amount also is subject to interest and an additional income tax. The interest imposed is equal to the interest at the underpayment rate plus one percentage point, imposed on the underpayments that would have occurred had the compensation been includible in income for the taxable year when first deferred, or if later, when not subject to a substantial risk of forfeiture. The additional income tax is equal to 20 percent of the compensation required to be included in gross income.
Income taxes, interest penalties for the late payment of income taxes, and the 20 percent excise tax can largely destroy the value of deferred compensation that is subject to 409A. Thus, avoiding the scope of 409A or complying with its requirements is a critical task in the design and operation of any deferred compensation arrangement.
Elective Deferral Timing
Generally, participants in a plan subject to 409A must elect to defer compensation earned during a calendar year before the beginning of that calendar year. For example, a participant must elect to defer salary for work performed in 2008 by Dec. 31, 2007. If an individual is newly eligible to participate in a plan, he or she must make any deferral election within 30 days of becoming eligible. (Note: Even for a new deferral, only compensation earned after the deferral election is made may be deferred -- retroactive elections are not permitted.)
Perfomance-based compensation is subject to special rules if it is based on performance period of at least 12 months. Participants may make deferral elections for such compensation no later than six months before the end of the period. For example, an election to defer a bonus based on performance in calendar year 2008 must be made before July 1, 2008.
Definite Time and Form of Distribution
Distributions may be made from a plan subject to 409A only upon the occurrence of a permissible trigger event. The permissible triggers are:
- Separation from service
- Specified time or a fixed schedule
- Change in control
- Unforeseeable emergency
Separation from service
An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer. The employment relationship is treated as continuing intact while the individual is on military leave, sick leave, or other bona fide leave of absence if the period of such leave does not exceed six months, or if longer, so long as the individual retains a right to reemployment with the service recipient under an applicable statute or by contract.
An independent contractor is considered to have a separation from service with the service recipient upon the expiration of the contract (or in the case of more than one contract, all contracts) under which services are performed for the service recipient if the expiration constitutes a good-faith and complete termination of the contractual relationship. An expiration does not constitute a good faith and complete termination of the contractual relationship if the service recipient anticipates a renewal of a contractual relationship or the independent contractor becoming an employee.
Presumption of Separation
An employee is presumed to have separated from service where the level of bona fide services performed decreases to a level equal to 20 percent or less of the average level of services performed by the employee during the immediately preceding 36-month period. An employee will be presumed not to have separated from service where the level of bona fide services performed continues at a level that is 50 percent or more of the average level of service performed by the employee during the immediately preceding 36-month period.
"Specified employees" must wait an additional six months after separation from service before receiving a distribution. "Specified employee" means a service provider who is a Key Employee of a service recipient any stock of which is publicly traded.
Specified employees are identified as of a "specified employee identification date." This date is December 31 (unless a different date is specified by the plan). If an employee is a key employee as of a specified employee identification date, the employee is treated as a key employee for the entire 12-month period beginning on the "specified employee effective date".
The "specified employee effective date" is the first day of the fourth month following the specified employee ddentification date (unless a different date is specified by the plan).
See specified employee for more information.
Effect of Corporate Transactions
Unlike in a qualified plan context, the stock sale of a corporate subsidiary does not cause employees of that subsidiary to experience a separation from service. An asset sale in which the employee transfers to the purchaser does, however, create a separation from service, although the buyer and seller may agree to apply the "same desk" rule to prevent a separation from service from occurring.
The 409A definition of disability is highly restrictive, and thus a common source of compliance problems. A service provider is disabled if:
- The service provider is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months;
- The service provider is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the service provider's employer; or
- The service provider is determined to be totally disabled by the Social Security Administration or Railroad Retirement Board.
Death means the actual death of the service provider, as one might expect.
Specified time or a fixed schedule
Amounts are payable at a specified time or pursuant to a fixed schedule if objectively determinable amounts are payable at a date or dates that are nondiscretionary and objectively determinable at the time the amount is deferred. An amount is objectively determinable for this purpose if the amount is specifically identified or if the amount may be determined at the time payment is due pursuant to an objective, nondiscretionary formula specified at the time the amount is deferred (for example, 50 percent of a specified account balance).
Specifying that a payment ia to be made in a specific calendar year (or a schedule of calendar years) is acceptable.
Change in control
A plan may permit a payment upon the occurrence of:
- a change in the ownership of the corporation,
- a change in effective control of the corporation, or
- a change in the ownership of a substantial portion of the assets of the corporation.
A change in the ownership of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, together with stock held by such person or group, constitutes more than 50 percent of the total fair market value or total voting power of the stock of such corporation.
A change in the effective control of the corporation occurs only on either of the following dates:
- The date any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 30 percent or more of the total voting power of the stock of such corporation; or
- The date a majority of members of the corporation's board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation's board of directors before the date of the appointment or election.
A change in the ownership of a substantial portion of a corporation's assets occurs on the date that any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation that have a total gross fair market value equal to or more than 40 percent of the total gross fair market value of all of the assets of the corporation immediately before such acquisition or acquisitions. (A higher amount may be specified by the plan provided it is set no later than the date by which the time and form of payment must be established.)
An unforeseeable emergency is a severe financial hardship to the service provider resulting from:
- an illness or accident of the service provider, the service provider's spouse, the service provider's beneficiary, or the service provider's dependent (as defined in Code section 152, without regard to section 152(b)(1), (b)(2), and (d)(1)(B));
- loss of the service provider's property due to casualty (including the need to rebuild a home
following damage to a home not otherwise covered by insurance); or
- other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the service provider.
Note that these hardship conditions are not the same as the conditions for a hardship withdrawal from a 401(k) plan.
Deemed Time of Distribution
A payment is treated as made upon the date specified under the plan if the payment is made:
- on such date; or
- on a later date within the same year, or, if later, by the 15th day of the third calendar month following the date specified under the plan if the service provider is not permitted, directly or indirectly, to designate the taxable year of the payment.
For example, a plan with a distribution date of June 30, 2010, may distribute the benefit on Dec. 31, 2010, without violating 409A. Similarly, a plan may make a distribution due on Dec. 31, 2010, on March 15, 2011, without violating 409A -- provided that the participant has no control over the delay.
In addition, a payment is treated as made upon the date specified under the plan and is not treated as an accelerated payment if the payment is made no earlier than 30 days before the designated payment date and the service provider is not permitted, directly or indirectly to designate the taxable year of the payment.
Prohibition on Acceleration of Payments
Generally, the time or schedule of any payment of deferred compensation subject to 409A cannot be accelerated. An impermissible acceleration does not occur, however, if payment is made in accordance with plan provisions or an election as to the time and form of payment in effect at the time of initial deferral (or a permitted modification) that provides for acceleration upon the occurence of a 409A trigger event. Plans may also always add death, disabilty, and unforeseeable emergency as distribution triggers, even as to amounts already deferred.
In addition, a plan may accelerate payments:
- to comply with a domestic relations order (as defined in Code section 414(p)(1)(B));
- to allow a Federal officer or employee in the executive branch to comply with an ethics agreement with the Federal government;
- to the extent reasonably necessary to avoid the violation of an applicable Federal, state, local, or foreign ethics law or conflicts of interest law;
- if the plan is a 457(f) plan, to pay Federal, state, local, and foreign income taxes due upon a vesting event (but only enough to pay the amount that would have been required to be withheld);
- to enforce a cashout provision, if the threshold is less than the Code Section 402(g) limit ($15,500 for 2007);
- to pay the FICA (or RRTA taxes) and to pay the required withholding for income taxes on compensation deferred under the plan (but only enough to pay the taxes and withholding);
- if such payments are included in income because of 409A violation;
- if the plan is terminated (subject to conditions);
- to prevent the occurrence of a nonallocation year for an ESOP;
- to reflect payment of state, local, or foreign tax obligations arising from participation in the plan that apply to an amount deferred under the plan before the amount is paid or made available to the participant;
- as satisfaction of a debt of the participant to the employer, where such debt is incurred in the ordinary course of their relationship, the reduction/distribution does not exceed $5,000 in any of the participant's tax years; and the reduction/distribution is made at the same time and in the same amount as the debt otherwise would have been due and collected from the service provider; and
- as part of a settlement of a bona fide dispute as to the participant's right to the deferred compensation.
See Treas. Reg. Â§1.409A-3(j) for more information on accelerated payments.
It is not a prohibited acceleration of payment if an employer waives or accelerates vesting, provided that the requirements of section 409A (including the requirement that the payment be made upon a permissible payment event) are otherwise satisfied with respect to the payment.
A schedule of installments may provide for an immediate payment of all remaining installments if the present value of the deferred amount to be paid in the remaining installment payments falls below a predetermined amount, provided that such feature including the predetermined amount is established by no later than the time and form of payment is otherwise required to be established. Any change in such feature including the predetermined amount is a change in the time and form of payment.
See Notice 2007-78 for more guidance on cashout features.
Permitted Redeferrals and Delays
Participants may defer or "push back" a payment if:
- The deferral does not take effect for 12 months;
- The deferral does not effect a payment scheduled within 12 months; and
- The new scheduled payment date is at least 60 months after the former scheduled payment date (except as to death, disability, or unforeseeable emergency.
Plan sponsors may delay payments if they reasonably anticipate the payments will not be deductible under Code Section 162(m), or will violate securities laws.
A plan subject to 409A must be in writing.
Notice 2010-6 expands and clarifies the correction options and relief granted by Notice 2008-113 to include a number of common document failures. Notice 2010-80 further expands the corrective program and provides additional relief.
Notice 2007-79 and others
- Notice 2006-100 -- reporting and withholding for 2005 and 2006
- Notice 2007-86 -- final regulations are effective Jan. 1, 2009
- Notice 2007-89 -- reporting and withholding for 2007
- Notice 2008-62 -- application of 457(f) and 409A to recurring part-year arrangements, especially for teachers and other school employees
- Notice 2008-115 -- interim guidance on reporting and withholding, effective beginning in 2008
- Notice 2009-49 -- guidance on effect of EESA stock purchases on 409A distributions
The final regulations (PDF) are effective Jan. 1, 2009.
During 2008, taxpayers are not required to comply with the requirements of the final regulations. Instead, they are required to operate a nonqualified deferred compensation plan in compliance with the plan's terms, to the extent consistent with section 409A and the applicable guidance (including Notice 2005-1). Where a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely upon either Notice 2005-1 or the final regulations. To the extent an issue is not addressed in Notice 2005-1 or other applicable guidance, taxpayers must apply a reasonable, good faith interpretation of the statute. Reliance upon the final regulations is treated as applying a reasonable, good faith interpretation of the statute.
See Notice 2007-86 for more information about the transition rules.
For research and reference, also try the Hypertext 409A Regulations (HTML).
Code Section 457A
For nonqualified plans that involve foreign entities, see also Code Section 457A.
NQDC plans that have distributions linked to qualified plans almost always violate 409A. NQDC plans that are linked to other NQDC plans (such as those of a former employer) may also violate 409A.
- Employment agreements
- Severance agreements not fully paid out and severance policies (even unwritten ones)
- Check definition of substantial risk of forfeiture, separation from service, and other terms
- Look at plan elections, payment triggers, timing of payments, and ability to change payouts
- Look to see if plan meets an exception to 409A
Private Letter Rulings
The IRS will not issue private letter rulings on the application of 409A to NQDC. See Rev Proc 2008-61, but may issue rulings on related matters.