Basics of Section 409A
By Section 409A addresses the taxation of nonqualified deferred compensation plans. A nonqualified deferred compensation plan is any arrangement that provides for the deferral of compensation, subject to exceptions. Section 409A is a response to executive compensation practices Congress felt were inappropriately beneficial.
Amounts deferred that do not meet the requirements of Section 409A generally are immediately includible in gross income (to the extent not subject to a substantial risk of forfeiture or previously included in income). Additionally, a 20% excise tax is imposed on the amount included in income. Interest at the federal penalty rate plus 1% is charged from the date of each failure. All such amounts are charged to the employee, rather than for the employer.
A key exception is provided for payments actually or constructively received no later than the 15th day of the third month after the end of the year in which the service provider becomes vested in them. This short-term deferral exception means deferrals are allowed so long as they are made no later than two and a half months after the end of the year of vesting.
Stock options and stock appreciation rights are also excepted from the definition of nonqualified deferred compensation if they meet the criteria of Reg. § 1.409A-1(b)(5). Those requirements include (1) the right must be issued on service recipient stock; (2) the exercise price must not be less than fair market value; (3) the right cannot include any feature that defers income inclusion beyond what would occur under Section 83; and (4) certain rules regarding the timing of income inclusion. Statutory stock rights, such as incentive stock options under Section 422 and employee purchase plan options under Section 423, are also exempted from Section 409A without needing to comply with the above requirements.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.