Compliance with section 409A of the Internal Revenue Code: Overview, definition, and example
What is compliance with Section 409A of the Internal Revenue Code?
Compliance with section 409A of the internal revenue code refers to the requirement that companies must follow the rules set forth in Section 409A, which governs nonqualified deferred compensation (NQDC) arrangements. These arrangements are agreements where employees, executives, or independent contractors agree to defer a portion of their compensation to be paid at a later date. Section 409A outlines specific rules about how and when these deferred payments must be structured to avoid significant tax penalties.
In essence, Section 409A regulates how deferred compensation is deferred, when it can be paid out, and under what circumstances it can be altered. Noncompliance with Section 409A can result in severe tax consequences, including the immediate inclusion of deferred compensation in taxable income, as well as additional penalties and interest.
Why is compliance with Section 409A important?
Compliance with Section 409A is important because failure to adhere to the rules can result in significant tax penalties for both the employer and the employee. If the rules are not followed properly, the deferred compensation may be taxed immediately, even if the employee has not yet received the payment, and the employee could face an additional 20% penalty tax.
For employers, noncompliance with Section 409A can lead to the invalidation of their deferred compensation arrangements, making it essential to carefully design and manage these compensation structures. Ensuring compliance helps avoid costly mistakes, protects both parties from tax issues, and keeps compensation arrangements in good standing with the IRS.
Understanding compliance with Section 409A through an example
Imagine a company offers its CEO a deferred compensation plan where a portion of their salary is paid out five years after the agreement is signed. Under Section 409A, the company must ensure that the deferral and payout terms comply with the regulations — such as specifying a fixed date for payout, prohibiting early withdrawals, and ensuring that any changes to the deferral agreement are carefully structured and timely.
If the company improperly alters the terms of the agreement, such as allowing the CEO to access the deferred salary earlier than agreed, the compensation could become immediately taxable to the CEO, and they could face a 20% penalty tax on the amount deferred. The company could also face penalties for not complying with the rules in Section 409A.
Example of compliance with Section 409A clause
Here’s how a compliance with Section 409A clause might appear in an employment agreement or compensation plan:
“The Company’s Deferred Compensation Plan is designed to comply with Section 409A of the Internal Revenue Code. All deferrals of compensation, elections for the timing of payments, and distributions will be made in accordance with the rules and regulations of Section 409A to avoid any penalties, including the 20% penalty tax. The Company agrees to structure any changes to the timing or form of payment of deferred compensation in compliance with Section 409A requirements.”
Conclusion
Compliance with Section 409A of the Internal Revenue Code is a critical aspect of managing nonqualified deferred compensation plans. It ensures that deferred compensation arrangements are structured in a way that avoids significant tax penalties for both the employer and the employee.
By adhering to Section 409A’s requirements, companies can protect their compensation plans from potential tax issues and penalties, and employees can avoid being unexpectedly taxed on their deferred compensation. Understanding and following the rules set out in Section 409A helps ensure that deferred compensation plans are both effective and compliant with federal tax laws.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.