Internal Revenue Code Section 409A was designed to address perceived abuses by executives who used their authority to accelerate distributions in deferred compensation plans while knowing that the companies they represented were approaching financial ruin. Their goal was to accelerate their plan distributions before the company went bankrupt, thus guaranteeing they could get all of the compensation the companies were planning to pay them at a later date. However, the actions of those executives unfairly benefited them over the interests of other employees and even the company’s shareholders. Therefore, in 2004 Congress passed Section 409A to regulate the timing of compensation payable on a deferred basis and to restrict executives from obtaining distributions on an accelerated or discretionary basis.

The application of 409A is extensive and can include phantom stock plans and other types of compensation

Much can be said of 409A and its reach. However, the most significant impact of Section 409A to compensation programs is that it limits the flexibility an employer might otherwise have with regard to payment form and timing. Programs subject to 409A may only make a distribution in the following circumstances:

• Death;
• Disability;
• Separation from service;
• Change in control;
• Unforeseeable emergency; and
• A specified date.

Most of these terms have special definitions under 409A that must be strictly followed.

When designing a phantom stock plan it is important to know whether the plan as designed would be subject to 409A so that the appropriate documentation can be established. Also, once a 409A plan has been implemented it is imperative to follow the regulations and IRS notices related to administration of the plan.

It is possible to create a phantom stock plan that avoids the application of 409A rules. The key requirement would be to (a) use cliff vesting (any incremental vesting must trigger immediate payment), and (b) pay benefits within 2½ months of the end of the year in which the awards vest.

For more information on IRC Section 409A, click here.