Section 409A was added to the Internal Revenue Code pursuant to the American Jobs Creation Act of 2004 in response to Congressional concerns about excessive executive compensation and executives’ ability to manipulate their compensation arrangements with the companies they manage. Section 409A requires that every deferred compensation plan or arrangement comply with certain strict guidelines. Plans or arrangements that are subject to Section 409A are required to be fully compliant with the final regulations under 409A by January 1, 2009.
What is “Deferred Compensation” Under 409A?
What is so striking about Section 409A, it its application to almost every type of plan or arrangement in which compensation is paid in a year subsequent to the year in which the services were performed by the service provider (i.e. the executive). Compensation is deferred when the service provider first has a legally binding right to the payment of compensation. Because the definition of deferred compensation is so broadly defined in Section 409A, it not only encompasses traditional nonqualified deferred compensation plans (i.e. where the executive elects to defer salary or bonuses), but also to payments under employment agreements, severance agreements and other similar arrangements. Tax-qualified plans such as 401(k) plans and IRAs are exempt from Section 409A. Also exempt from Section 409A are bona fide vacation, sick leave, disability pay and death benefit plans.
Section 409A Requirements
Section 409A specifically addresses when a service provider may make an election to defer payments under a deferred compensation plan or arrangement, when compensation under a deferred compensation plan or arrangement may be distributed, and how a service provider may delay the receipt of payments under a deferred compensation plan or arrangement.
Each deferred compensation plan or arrangement (including employment agreements, severance agreements and other similar arrangements) must be in writing and fully compliant with Section 409A by January 1, 2009.
What Happens if the Section 409A Requirements are Not Met?
Failure to comply with Section 409A will have severe consequences to the service provider. Those consequences include i) immediate taxation of all amounts deferred under the plan or arrangement; ii) assessment of an interest penalty for the underpayment of taxes during the deferral period; and iii) an additional 20 percent penalty tax. In addition, the service recipient (employer) will have additional tax reporting requirements under Section 409A.
Immediate Action is Necessary
All documents, plans, arrangements or contracts that may defer compensation must be reviewed immediately. Among these documents are:
- Deferred compensation plans and/or agreements
- Employment agreements
- Severance plans and/or agreements
- Change in control agreements
- Stock appreciation rights agreements
- Expense reimbursement policies
Stark & Stark can assist you in reviewing and amending your deferred compensation plans and arrangements and will work to ensure that all documents are compliant with Section 409A by January 1, 2009. We can also assist you with new plans and arrangements that will be Section 409A compliant when drafted.