Internal Revenue Code section 409A
Encyclopedia
Section 409A of the Internal Revenue Code regulates the treatment for federal income tax
purposes in the United States
of “nonqualified deferred compensation” paid by a "service recipient" to a "service provider". Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, as well as entities that provide services (an LLC, for example, could be a service provider).
, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron
executives accelerating the payments under their deferred compensation
plans in order to access the money before the company went bankrupt
, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt
tax doctrine.
for non-compliance is severe in that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income.
Under regulations issued by the IRS
, Section 409A applies whenever there is a “deferral of compensation,” which occurs whenever an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension
and 401(k)
plans, and welfare benefits including vacation
leave, sick leave
, disability pay, or death benefit plan. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.
1) restrictions on the timing of distributions;
2) restrictions against the acceleration of benefits; and
3) restrictions on the timing of deferral elections.
Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances:
1) the employee’s separation from service;
2) the employee's becoming disabled;
3) the employee's death;
4) a fixed time or schedule specified under the plan;
5) a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation
; or
6) the occurrence of an unforeseeable emergency.
In addition, Section 409A provides that with respect to certain “key employees” of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier.) Key employees are generally the top 50 employees with pay above $150,000.
The rules restricting the timing of election
s as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories:
(1) initial deferral elections; and
(2) subsequent deferral elections.
As a general rule, initial deferral elections must be made no later than the close of the employee's taxable year immediately preceding the service year. The term “initial deferral elections” includes all decisions, whether made by the employee or employer, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections.
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
purposes in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
of “nonqualified deferred compensation” paid by a "service recipient" to a "service provider". Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, as well as entities that provide services (an LLC, for example, could be a service provider).
History
Section 409A was added to the Internal Revenue CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
executives accelerating the payments under their deferred compensation
Deferred compensation
Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a date after which that income is actually earned. Examples of deferred compensation include pensions, retirement plans, and stock options...
plans in order to access the money before the company went bankrupt
Enron scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...
, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt
Constructive receipt
For federal income tax purposes, the doctrine of constructive receipt is used to determine when a cash-basis taxpayer has received gross income. A taxpayer is subject to tax in the current year if he or she has unfettered control in determining when items of income will or should be paid...
tax doctrine.
Basic Summary
Section 409A generally provides that a “nonqualified deferred compensation plan” must comply with various rules regarding the timing of deferrals and distributions. The penaltySanctions (law)
Sanctions are penalties or other means of enforcement used to provide incentives for obedience with the law, or with rules and regulations. Criminal sanctions can take the form of serious punishment, such as corporal or capital punishment, incarceration, or severe fines...
for non-compliance is severe in that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income.
Under regulations issued by the IRS
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
, Section 409A applies whenever there is a “deferral of compensation,” which occurs whenever an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension
Pension
In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
and 401(k)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
plans, and welfare benefits including vacation
Vacation
A vacation or holiday is a specific trip or journey, usually for the purpose of recreation or tourism. People often take a vacation during specific holiday observances, or for specific festivals or celebrations...
leave, sick leave
Sick leave
Sick leave is time off from work that workers can use during periods of temporary illness to stay home and address their health and safety needs without losing pay. Some workplaces offer paid sick time as a matter of workplace policy, and in few jurisdictions it is codified into law...
, disability pay, or death benefit plan. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.
Timing Restrictions
Section 409A’s timing restrictions fall into three main categories:1) restrictions on the timing of distributions;
2) restrictions against the acceleration of benefits; and
3) restrictions on the timing of deferral elections.
Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances:
1) the employee’s separation from service;
2) the employee's becoming disabled;
3) the employee's death;
4) a fixed time or schedule specified under the plan;
5) a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
; or
6) the occurrence of an unforeseeable emergency.
In addition, Section 409A provides that with respect to certain “key employees” of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier.) Key employees are generally the top 50 employees with pay above $150,000.
The rules restricting the timing of election
Election
An election is a formal decision-making process by which a population chooses an individual to hold public office. Elections have been the usual mechanism by which modern representative democracy operates since the 17th century. Elections may fill offices in the legislature, sometimes in the...
s as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories:
(1) initial deferral elections; and
(2) subsequent deferral elections.
As a general rule, initial deferral elections must be made no later than the close of the employee's taxable year immediately preceding the service year. The term “initial deferral elections” includes all decisions, whether made by the employee or employer, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections.