Section 409A: Overview, definition and example
What is Section 409A?
Section 409A refers to a provision of the Internal Revenue Code (IRC) that governs the taxation of nonqualified deferred compensation (NQDC) plans. It sets strict rules for the timing of deferrals and distributions of deferred compensation to ensure that these amounts are taxed properly. The goal of Section 409A is to prevent employees or executives from delaying the tax payment on compensation for personal gain, while also establishing clear guidelines for the structure and operation of deferred compensation plans.
For example, Section 409A applies to arrangements where an employee defers a portion of their salary or bonus to a later date, such as in retirement plans or stock options.
Why is Section 409A important?
Section 409A is important because it ensures compliance with the tax laws concerning deferred compensation, preventing the mismanagement of tax liabilities by employees or employers. If a nonqualified deferred compensation plan does not comply with Section 409A, it can result in significant tax penalties, including the immediate taxation of deferred amounts, an additional 20% tax penalty, and interest on underpaid taxes.
By adhering to Section 409A’s rules, both employers and employees can avoid these penalties and ensure that their deferred compensation is taxed appropriately and according to the law.
Understanding Section 409A through an example
A company offers an executive deferred compensation plan where the executive can choose to defer a portion of their annual salary to be paid in the future. Under Section 409A, the executive must make this election before the start of the year in which the compensation is earned. The deferred amount cannot be paid out earlier than the specified dates or events, such as retirement, death, or disability. If the plan does not comply with the timing rules, the deferred amounts will be subject to immediate taxation, additional penalties, and interest.
An example of a Section 409A clause
Here’s how a Section 409A compliance clause might appear in a contract:
“The Employer has established this deferred compensation plan in compliance with Section 409A of the Internal Revenue Code. Any deferral elections made by the Employee must be completed in accordance with the timing requirements outlined in Section 409A. The Employee understands and agrees that any distribution under this plan shall be made in compliance with Section 409A’s rules regarding the timing and form of payment. If any provision of this plan is found not to comply with Section 409A, the Employer agrees to amend the plan to bring it into compliance.”
Conclusion
Section 409A is a critical provision in the tax code for deferred compensation plans, ensuring that nonqualified deferred compensation is taxed properly and that employees are not unfairly delaying tax payments. Employers and employees must adhere to the rules set out in Section 409A to avoid tax penalties and ensure compliance. A well-drafted Section 409A compliance clause in contracts or benefit plans ensures that both parties understand their responsibilities and the tax implications of deferred compensation.
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.