Section 409A of the United States Internal Revenue Code regulates the taxation of nonqualified deferred compensation. It is important for companies to understand the intricacies of Section 409A because violations of the rules can result in major consequences. Noncompliance with Section 409A can trigger severe penalties for the employees and/or employers involved and can cause harm to a company’s reputation.

The term “nonqualified deferred compensation” is defined broadly under Section 409A. It includes compensation which is or may be paid in a year following the year in which a legally binding right to payment arises. Examples of plans that may be subject to Section 409A include certain employment agreements, equity award plans, long-term bonus deferral plans, and separation agreements.

Section 409A applies to the compensation of “service providers,” which may encompass employees, directors, independent contractors, partners, and other third-party service providers. The service recipient is the company or affiliated entities receiving services from the service provider.

There are a number of exceptions and exemptions to Section 409A. Compensation payments can be structured to rely on the short-term deferral exception. If the compensation is paid shortly after the end of a fiscal year (i.e., before March 15 of the year following the relevant year) in which the payments are no longer subject to a “substantial risk of forfeiture” (SROF), the short-term deferral exception may apply. A SROF exists when the deferred compensation payment is conditional on the performance of substantial future services or on hitting certain performance metrics. In addition, certain severance payments may be exempt from Section 409A, such as those only payable upon an involuntary termination. Certain deferred compensation arrangements under tax-qualified plans are also exempt from Section 409A.

The penalties associated with Section 409A noncompliance include a 20% penalty tax imposed on the deferred compensation amount and increased interest penalties on late payments of the income tax due. In addition, the total deferred compensation amount is included in the service provider’s taxable income for the tax year of the violation.

In order to stay compliant with Section 409A, companies should take a methodical approach to ensuring that nonqualified deferred compensation arrangements do not run afoul of the regulations. In particular, companies can be strategic about the timing of deferral elections. Pursuant to Section 409A, an employee must make an election to defer compensation by the end of the taxable year before the taxable year in which the compensation is considered earned. However, for a performance-based bonus, the employee has until the date that is six months before the end of the performance period to make the deferral election. Once the election is made, it is generally irrevocable and changes to the deferral election can be considered a violation of Section 409A.

Companies can also prevent triggering adverse tax consequences under Section 409A by clearly specifying the form and timing of payment(s) in nonqualified deferred compensation plans. Payments can be made up to 30 days prior to the specified payment date. Acceleration of payments of deferred compensation earlier than this are prohibited in most circumstances.