IRS Section 409A

Section 409A regulates taxation of nonqualified deferred compensation. It has an extensive set of rules. The Section outlines the specific requirements for the timing of deferral elections and the designation of the time and form of payment of deferred amounts under nonqualified deferred compensation plans, and imposes tax penalties if the requirements are not met. The tax penalties for noncompliance are severe and are imposed on the employee rather than the employer. Although the employer can face penalties for failing to properly withhold or report.


Section 409A addresses the compensation of service providers. A service provider can be an employee, independent contractor, a partner or a director serving on the board if he receives compensation for the services. An individual or a company can be service recipient. 


Section 409A applies when the right to deferred compensation emerge regardless to whether it was exercised or not. For example, if an employment agreement was signed that stated that certain amount of money will be paid to an employee at some time in the future upon happening of a certain event, Section 409A will govern even if the event never occurs and accordingly compensation is not paid.


Section 409A covers equity compensation arrangements where the receipt of the benefits is deferred in time. Let’s review which ones fall under this category. Stock options granted with an exercise price below fair market value per share on the grant date are considered deferred compensation. Stock options and SARs granted with an exercise price equal to the fair market value of the shares on the grant date are generally not subject to Section 409A. Restricted stock is also generally not subject to Section 409A unless it specifically provides for a compensation deferral feature. Restricted Stock Units are subject to Section 409A if they are not required to be settled within 2 1/2 months following the end of the year in which they vest. The same concept applies to phantom shares. If the award vests and the stock or cash is delivered to the recipient within 2½ months after the end of the taxable year in which the award vests, these awards generally are exempt from Section 409A.Stock Appreciation Rights are exempt if the exercise price is not less than the fair market value of the stock on the grant date and the grant does not include any additional deferral features.


Penalties for Noncompliance


The tax penalties for violating Section 409A are quite severe and are imposed on the employee and the employer. They include:


     Compensation under the non-compliant arrangement (and any similar arrangements that must be aggregated with it) is included in income when it vests rather than when exercised or stock is sold;

     A 20% penalty tax is imposed on the amount involved in addition to regular income and employment taxes and potential state taxes;

     An increased interest rate is imposed on the late payment of the income tax due on the compensation.


Violations and drastic consequences can be avoided if an Equity Compensation Plan is developed by an experienced business attorney and both the employers and their service providers receive a comprehensive legal consultation regarding the type of equity being granted and its tax treatment in various situations.

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