section 409A of the internal revenue code - deferred compensation rules

Outten & Golden attorneys are familiar with Internal Revenue Code Section 409A Deferred Compensation Rules and understand how these rules affect deferred compensation, equity compensation, and separation pay. We review our clients’ existing plans and employment agreements to discuss alternative arrangements if the pre-409A arrangements are no longer appropriate under the current rules and recommend tax counsel when needed.

On April 10, 2007, the IRS and the Treasury released Internal Revenue Code Section 409A, new laws that affect deferred compensation, including severance pay and employment compensation. Section 409A generally provides that a “nonqualified deferred compensation plan” must comply with various rules regarding the timing of deferrals and distributions. Section 409A applies whenever there is a “deferral of compensation,” which occurs when an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year.

There are various exceptions to Section 409A, including qualified plans like pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or a death benefit plan. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.

The penalty for non-compliance is severe in that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income.