A plan or arrangement containing non qualified deferred compensation features may have to comply with the requirements of Section 409A of the Internal Revenue Code. Non qualified deferred compensation features can be present in any plan or arrangement which provides payment for services subsequent to the year in which the services are performed. A contract providing, for example, that an employee will be paid on December 31, 2017 for performing services for his or her employer in 2016 could be subject to Section 409A. Non qualified deferred compensation features can be in bonus plans, employment contracts, plans and arrangements for the payment of retirement benefits, phantom stock and stock appreciation plans, discounted stock options, separation and retention plans, post retirement fringe benefits, certain types of split dollar life insurance arrangements, top hat plans, Section 457(f) plans, change of control agreements and similar plans and arrangements.
Many types of deferred compensation arrangements are excluded from Section 409A including benefits under qualified retirement plans such as Section 401(k) plans; tax deferred annuities (Section 403(b) plans); simplified employee pensions (SEPP plans); SIMPLE retirement accounts; bona fide vacation, sick leave, disability and death benefit plans; certain severance arrangements; benefits which are paid before March 15 of the year immediately following the year in which they vest; and equity compensation arrangements (stock options, phantom stock and stock appreciation rights) the exercise price which is based on fair market value of the underlying stock on the grant date of the option or right.
The requirements of Section 409A are complex. The terms of a plan or arrangement subject to Section 409A must be incorporated into a written document and the parties to the plan or arrangement must follow those terms. A plan or arrangement subject to Section 409A must contain the following provisions:
- Specify when compensation is to paid under the plan or arrangement. Compensation can only be paid on death, disability, change of control, severance of employment or at a time specified in the governing document.
- Definitions of the payment event (death, disability, change of control, severance, et cetera) must be incorporated into the governing document.
- Certain restrictions must be imposed on payments to employees of public companies.
- An employee generally may only elect to defer compensation before the year in which he or she renders service with respect to which deferred compensation will be paid
- The time and form of distribution specified under the plan or arrangement can be changes only under limited circumstance.
The tax consequences of failing to comply with Section 409A are severe. The employee is responsible for taxes and penalties for the year in which the failure occurs although the employer is required to withhold income taxes resulting form the violation and report the violation to the government. The taxes and penalties which may be imposed on a non compliant Section 409A benefit are:
- The present value of the benefit is subject to ordinary income tax at the time of failure. If an employee is entitled to a benefit of $50,000 a year for ten years and the arrangement fails to qualify under section 409A at the time the benefit becomes vested, the $500,000 value of the entire interest, discounted for interest, is subject to Federal income tax at the time of failure. The present value of the benefit may also be subject to state income tax.
- The benefit is also subject to a Federal excise tax equal to twenty percent of its present value.
- The benefit may be subject to another excise tax equal to the Internal Revenue Service interest rate on tax deficiencies plus one percent (currently a total of 4.4%) of the vested amount that accrues each year under the plan or arrangement.
Taxes on a non compliant benefit under Section 409A can, under certain circumstances, equal the present value of the benefit.
Because the requirements of Section 409A are complex, each plan or arrangement potentially subject to these rules should be carefully reviewed to insure compliance with the statute. This is an overview of Section 409A and does not address all of the requirements and exceptions under the statute.