Section 409A

A tax code provision relating to deferred compensation arrangements, including stock options, severance arrangements and bonus plans. If the relevant compensation arrangement fails to comply with Section 409A, the employee will be subject to severe tax consequences.

Section 409A “became a thing” on January 1, 2005 as a result of provisions within the American Jobs Creation Act of 2004. It was created, in part, as a response to the destructive practices of Enron executives prior to the company’s bankruptcy. Specifically, executives would accelerate payments governed by their deferred compensation plans in order to access these funds more quickly. Because Section 409A defines “deferral of compensation” so broadly, this regulation has far-reaching effects within the U.S. economy.

As a result of this regulation, non-qualified deferred compensation must meet strict timing guidelines in regards to both distributions and deferrals. Essentially, whenever an employee has a right to compensation in a taxable year that either will or may be payable in a subsequent taxable year, Section 409A requirements apply to this reality. Certainly, there are exceptions to this scenario, but they must be treated with great care because mucking this part of the tax code up can cost everyone involved. With that said, sick pay, death benefit plans, paid vacation, 401(K) plans, disability pay and pensions are generally considered “qualified” and therefore are not governed by Section 409A mandates.

Section 409A does indeed apply to restrictions on timing related to deferral elections and distributions as applied to non-qualified deferred compensation. As a result of this regulation, any non-qualified deferred compensation may generally only be paid out when the employee no longer works for the petitioning company, becomes disabled or dies; conditions of a qualifying fixed schedule under the plan are met, the ownership and/or effective ownership of the petitioning company is altered or an unforeseeable emergency meets exception-related criteria. For reasons that do not totally make sense, it is the recipient of distributions (not the company that provides them) that violate the terms of Section 409A that tend to incur the most severe penalties as a result of plan non-compliance. Given that an average (non-executive) employee does not have both advanced legal and accounting degrees and is unlikely to understand that the money he or she is receiving does not meet obscure tax code conditions, this is a strange reality when applied to non-executives and non-managers.

 

EXAMPLE:

Employee: “I never got to take my wife on a honeymoon. I think I’ll cash out some of my employee stock benefits and finally take her to Hawaii.”

Accountant: “Due to Section 409A, I can’t advise that. You can have the money when you quit, retire, become disabled or die.”

Employee: “Great. (Sighs) Looking forward to it.”