Enacted in 2004, Internal Revenue Code Section 409A regulates compensation paid on a deferred basis. That is, if an employee has a legally binding right to receive income in one calendar year, but does not receive that income until a subsequent calendar year, that income is subject to 409A unless an exception applies.
The application of 409A is extensive and includes phantom stock plans and other types of compensation, such as the following:
- Agreements to defer salary or bonuses
- Agreements to make up for amounts not allowable under qualified retirement plans such as 401(k) plans
- Supplemental executive retirement plans
- Stock option and stock compensation plans (although numerous potential exemptions often apply)
- Restricted stock unit plans
- Bonus arrangements (including phantom stock)
- Expense reimbursement plans
- Severance arrangements – including those in employment or other agreements
- Deferred payment or “earnout” arrangements pursuant to merger or business purchase agreements
- Deferred payment in connection with a covenant not to compete
- Payments deferred past the date of performance such as royalty or similar payments to artists for subsequent sales, distributions, records, broadcasts, etc.
Qualified retirement plans, health and medical plans, employment claim settlements and foreign plans are all exempted from the requirements of 409A. Also, plans that provide for payment within the “short term deferral exception” can avoid the restrictions of 409A.
Non-compliance with 409A may subject plan participants to the following harsh results:
- All compensation still deferred under the plan is taxed as soon as it becomes vested (even if payable later),
- Premium interest on that tax accrues from the vesting date at the rate applicable to tax underpayments plus 1%, and
- The employee is subject to a 20% additional tax on the taxable amount.
- In addition, it is possible that certain state and local income tax sanctions could arise. For example, California levies yet an additional 20% and premium interest penalties.