United States: Section 409A: Top 10 Rules For Compliant Non-Qualified Deferred Compensation

Internal Revenue Code Section 409A regulates nonqualified deferred compensation (NQDC) plans and arrangements, which are commonly used to provide supplemental compensation to key executives. Complying with Section 409A is critically important because noncompliance will result in an executive being subject to income tax in the year NQDC becomes vested, regardless of when the NQDC is scheduled to be paid. In addition, an executive must pay a 20% excise tax on noncompliant NQDC, as well as interest on any late payment of income taxes. Employers may be subject to penalties and interest for failure to timely report and withhold income taxes with respect to NQDC that does not comply with Section 409A.

Given the draconian consequences of violating Section 409A, it is critical that HR professionals, as well as executives, understand basic elements of Section 409A and the impact Section 409A has on the design of NQDC plans and arrangements.

Over four hundred pages of regulations have been issued under Section 409A. The following is a summary of ten principles that are central to understanding the scope and impact of Section 409A.

  1. Broad impact on executive compensation arrangements. Section 409A defines NQDC as a legally binding right to compensation that is payable (and taxable) in a later tax year. Thus, Section 409A can impact not only traditional NQDC plans, such as salary deferral plans and supplemental executive retirement plans (SERPs), but also arrangements such as executive employment agreements, severance agreements and unwritten bonus programs. These rules apply not only to executives but all employees, as well as independent contractors.
  2. Elections of time and form of payment. Generally, initial elections to defer the payment of compensation must be irrevocable before the beginning of the year in which the compensation is earned. Initial deferral elections to defer payment of performance-based deferred compensation can be made six months before the end of the performance period in which the compensation is earned, but only if the performance period is at least 12 months long, the executive continuously works throughout the performance period, and the performance-based compensation is not readily ascertainable at the time the deferral election is made. Any subsequent changes to elections of time and form of payment of NQDC must be made at least 12 months prior to the scheduled payment date and must defer payment for at least five years. The subsequent election is not effective for 12 months.
  3. Limited distribution events. Distribution of NQDC may only be made upon (i) death, (ii) disability, (iii) separation from service, (iv) a fixed date specified at the time of deferral, (v) a change of control, or (vi) hardship. As noted below, most of these terms are specially defined under Section 409A.
  4. Acceleration of NQDC is generally prohibited. Under Section 409A, the accelerated payment of NQDC is generally prohibited. This is true whether acceleration occurs at the discretion of the executive or the employer. There are a few exceptions to this rule. However, even accelerated payment of NQDC upon plan termination is strictly limited.
  5. Section 409A has unique definitions for common terms. Application of Section 409A is particularly difficult because commonly defined terms have a much different definition under Section 409A. For example, the term "plan" is defined to include all plans of the same type that cover a single individual. A "separation from service" occurs only if the executive no longer works for any member of the employer's controlled group. If the executive continues consulting at a level that is at least 50% of the level of his or her prior service (as measured over the preceding 36 months), there is a presumption that no separation from service has occurred. If the executive works at a level that is less than 20% percent of his or her prior service, there is a presumption that a separation from service has occurred. Any Section 409A analysis must take into account these special definitions.
  6. Plans of the same type are treated as a single plan. Plans of the same type are treated as a single plan for purposes of determining compliance with Section 409A. There are nine types of plans. Thus, for example, a Section 409A violation with respect to a participant's salary deferral plan will also constitute a violation with respect to the participant's bonus deferral plan and any Section 409A penalties will be calculated based on the total NQDC provided under both plans.
  7. Short-term deferrals. Short-term deferrals are not treated as NQDC that is subject to Section 409A. Compensation that is paid not later than 2˝ months after the close of the plan year in which such compensation vests, is not considered NQDC. If the plan permits the possibility of payment after the 2˝-month limitation, it will not qualify as a short term deferral even if the compensation is actually paid within the 2˝ month period. Also, vesting is uniquely defined under Section 409A. For example, non-compete provisions do not delay vesting and, generally, elective deferrals, such as salary deferrals, are never considered unvested.
  8. Separation pay. Generally, severance pay may be NQDC that is subject to Section 409A unless it satisfies one of several exceptions set forth in the regulations. For example, severance pay due to involuntary separation that (i) does not exceed the lesser of (A) Two times the executive's annual compensation for the preceding year, or (B) Two times the compensation limit applied to qualified retirement plans (i.e., $530,000 for 2016) and (ii) is paid no later than end of second year after the year of the separation is exempt from Section 409A. Special rules apply in determining whether separation for "good reason" is considered involuntary separation.
  9. Six-month delay for publicly traded companies. Payments of NQDC to key employees of public companies may not commence for at least six months following separation from service.
  10. Substitutions will be scrutinized. Under the Section 409A regulations, payment of current compensation in exchange for NQDC to be paid in the future may be treated as an impermissible acceleration of the NQDC in violation of Section 409A. For example, it is critical to examine the impact of a restated employment agreement on existing NQDC to determine whether an impermissible substitution has occurred.

As indicated above, Section 409A imposes many complex rules on NQDC. Fortunately, the IRS has developed a program to correct Section 409A violations that are quickly discovered and properly correctly. It is critical to consult legal counsel before designing NQDC plans and arrangements to ensure compliance with Section 409A. Should a Section 409A violation occur, e.g., a failure to timely pay NQDC, it is important to consult legal counsel for assistance in correcting such violation to minimize the impact of Section 409A.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.