What is 409A Income?

Many in the industry have had a long-standing criticism of Section 409A. Even the IRS has recognized some of these concerns, in terms of the complexity and sensibleness of the law. But, those who the new law applies to are still obligated under law to pay up as defined in Section 409A. Since the tax system in the US is based on the tax payer honoring their obligations to pay taxes, the IRS (Internal Revenue Service) does its job to encourage non-filers to step up and pay their taxes voluntarily or face severe penalties. The reason why people fail to pay their taxes varies, from personal problems, to the fear because of not filing for an extended period of time, to a belief that any penalties are not going to outweigh the expenses and the trouble of filing one’s taxes. However, not filing taxes in the US is a criminal violation which is the reason why all citizens should pay their taxes by following the tax rules that apply to them to avoid any actions taken against them by the IRS.

Keeping that in mind, one of the areas that often seem to confuse tax filers in the US is the relatively new Section 409A in the Internal Revenue Code. If you are one of those people who are having trouble understanding the new tax law, the following lines are for you. 

History of Section 409A

Section 409A was first enacted in October 2004 under the Section 885 of the American Jobs Creation Act, which became effective at the starting of 2005. The law basically applies to the compensation that workers earn in a year but is not paid until an upcoming year in the future. This is more commonly known as a nonqualified deferred compensation. While the impact of Section 409A is far-reaching it is important to note that it does now apply to other qualified plans such as Section 401(k) plan or Section 457(b) plan or Section 403(b) plan. The enactment of Section 409A was brought into place because of the practices of Enron executives. The law was also in response to a long history of tax-timing abuse. 

Under Section 409A, any amounts deferred under the nonqualified deferred compensation plan, unless it meets certain requirements, will be included in the gross income, unless the amount is subject to a risk of forfeiture. Additionally, a deferred amount is also going to be subject to an additional 20% federal income tax, penalties and interest, but, these requirements vary from state to state. The implication of Section 409A is far-reaching due to the broad definition of “deferral of compensation.”

Keeping that in mind, Section 409A will apply to the following:

  • Amounts deferred after 2004.
  • Amounts deferred before 2005 which weren’t vested by December 2004, and
  • Amounts deferred before 2005, but where the arrangement was materially modified after October 2004. 

Since this law has been enacted, the IRS has issued around twelve notices, which regard various factors of the new law. The IRS and the Treasury Department had issued proposed regulations in 2005 which aimed to interpret Section 409A. These regulations were published in April 2007. While the final regulations were designed to be effective from January 2008, they did not become active until January 2009, a good two years after these regulations had been finalized. All terms, agreements and practices that have got to do with deferral of compensation need to comply with the regulations given under Section 409A in form and in operation. 

Framework of Section 409A

Under the statute, Section 409A to avoid deferred compensation from becoming included in gross income for a particular year, the arrangement needs to meet three requirements, which are as follows:

  • Distributions — Any amount deferred needs to be payable upon either separation of service, death, disability or any unforeseeable emergency, or a specific date and time. 
  • Acceleration — A plan cannot allow any acceleration of the time of the payment under the plan, except under the conditions provided in the regulations
  • Elections — An election to defer compensation for services that have been performed in any given year needs to be made prior to the starting of that tax year. Also, any elections on the time and form of the payment needs to also be made by that time. 

In case of failing to comply with Section 409A, the consequences are severe, which is why special care needs to be given to making sure one complies with the guidelines in Section 409A. There are three consequences if a nonqualified deferred compensation plan files to meet the requirements during a given taxable year:

  • Income Inclusion — All compensation that was previously deferred under the plan is going to be included in the person’s gross income to the extent that 1: the amount is not subject to any substantial risk of being forfeited, and 2: the amount has not been included in the person’s gross income previously. 
  • Interest — The participant is also going to be subject to interest, which is calculated at the underpayment rate with the addition of 1%, based on the underpayment which would have occurred if the deferred compensation been included into the income in the year that was first deferred.
  • Penalties — The participant is going to be required to pay a penalty that’s equal to 20% of the amount required to be included in the income. 

Qualified and Non-Qualified Deferred Compensation

There is a distinction made between ‘deferred compensation plans’ and ‘deferral of compensation’ in Section 409A. The use of the word ‘plan’ means agreement, program, method or any other arrangement that applies to an individual. According to Section 409A, unless a deferred compensation drops below the specified set of qualified deferred compensation, the IRS will consider it as an unqualified deferred compensation. The various categories of unqualified deferred compensation according to the IRS are:

  • Certain foreign plans
  • Stock options
  • Certain welfare benefits
  • Qualified employer plans or retirement plans
  • Section 457 plans

Definition of Nonqualified Deferred Compensation Plan

According to the statute a nonqualified deferred compensation plan will include any plan or arrangement that offers for the deferral of compensation. A plan can provide for the deferral of compensation only when under the terms of the plan and the relevant facts and given the circumstances, the service provides is able to obtain a legally binding right for compensation of a single taxable year, that may be payable in a later year to the service provider. According to the regulations, while there is no legally binding contract present, where the service recipient has the discretion to unilaterally reduce the amount of the compensation. The same will not be true for instances the compensation paid is reduced or eliminated altogether. Such as, in cases of the application of a nondiscretionary and objective provision which leads to the risk of a forfeiture. 

For instance, if an employer agrees to pay their employee a bonus in the following year that is equal to 5% of the employee’s annual salary, in such situations, the arrangement can be taken under ‘deferral of compensation’. This is mainly because of the fact that the employee obtained the right for a bonus in a previous year, which was implemented in the following year. If the two parties had made the same agreement, but the employer had a unilateral discretion regarding the amount of the bonus, then the arrangement would not provide the grounds for a deferral of compensation. That being said, if the amount of the bonus is tied to a certain criteria of performance objective of the company, then the arrangement will provide for a deferral off compensation, despite there being a risk of the performance criteria not being met by the employee, as a result, either some or all of the bonus amount may not be paid to the employee. 

Keeping this in mind, the definition of ‘Deferred compensation’ is extremely broad and sweeps in almost any nondiscretionary promise to pay the compensation later, either in the form of an incentive or a bonus, or any agreement, such as one for employment, severance, expense reimbursement, supplemental retirement or any other compensation-based agreement. Consequently, any kind of agreement or contract that offers a compensation or any kind of benefit in a future year will be subject to Section 409A. When there is a legally binding right to any future payments it should be assumed that the deferred amount is going to be subject to Section 409A, unless the arrangement meets some kind of regulatory or statutory exemption. 

Arrangements that are Exempt from Section 409A

The following are the arrangements and plans that are exempt from Section 409A;

  • Tax-sheltered annuity arrangements (Section 403(b))
  • SEPs, SIMPLE and SARSEP SIMPLE plans (Section 408)
  • Retirement plans (Sections 401(a) or 401(k))
  • Excess benefit arrangements by qualified governments (Section 415(m))
  • Qualified annuity (Section 403(a))
  • All plans involving deductible contributions to Code Section 501(c) (18) trust
  • Any eligible deferred compensation plans (Section 457(b))
  • Vacation or sick leave, any compensatory time, disability or death benefit plans

Section 409A does assign penalties for compliance failure to the recipient of deferred compensation (service provider) and not to the company that is offering the compensation (service recipient). There are specific penalties that have bene written into law and these non-compliance penalties can be quite severe, which is why the rules and regulations governing them must be followed. The good news is that Section 409A does not have any impact on FICA (Social Security and Medicare) tax.  

Compliance with Section 409A

If possible, its best to try and avoid Section 409A. While structuring the compensation arrangements, service recipients need to first consider if there is any plausible design or a good alternative which will not be subject to Section 409A. For instance, while considering any stock-based deferred compensation, service recipients should take into consideration restricted stock or full FMV stock options or SARs, which when appropriately structured are not going to be subject to Section 409A, while discounted stock options or phantom stock and stock rights which do not involve service recipient stocks are going to be subject to Section 409A. 

When it comes to incentive compensation packages or bonus plans, the inclusion of a ‘substantial risk of forfeiture’ provision can allow the amount deferred to be exempt under the rule of short-term deferral. While drafting employee agreements or severance agreements, an employer should take advantage of the ‘involuntary’ separation pay exception, including “good reason” employment terminations, and from exemption from any post-termination reimbursements or indemnifications. Additionally, special care ought to be taken to not modify grandfathered amounts, as in, any amounts that were deferred or vested as of December 31st, 2004. By doing so, one is able to avoid the possibility that by failing to comply with Section 409A, the amounts deferred is going to be subject to early taxation or penalty. 

If any particular compensation arrangement is not able to be structured so that it is exempt from Section 409A, then it should comply with both the regulatory and statutory requirements. The three requirements for deferred compensation arrangements which are subject to Section 409A are, limited distribution events, prohibition on acceleration of time of payment, and specific rules on the timing of the deferral elections. 

A ‘nonqualified deferred compensation’ plan has to comply with Section 409A in both operations and form. Keeping that in mind, every agreement, plan or arrangement that’s considered to be deferred compensation under Section 409A has to be produced in writing. Since the scope of Section 409A is broad, and is not limited to complex or abusive arrangements, the rules and regulations must be followed strictly to avoid any severe consequences that can impact both the employee as well as the employer.