Section 409a of the internal revenue code establishes guidelines for the treatment of "nonqualified deferred compensation." Essentially, this refers to any money received in a future year for work you perform during the current year, such as bonuses, stock options, and supplemental retirement plans. Here's what you need to know about section 409a and what it could mean for your taxes.
What is section 409a?
As I mentioned, Section 409a governs the treatment of nonqualified deferred compensation, which basically refers to any compensation outside of a "qualified" plan such as a 401(k) that is paid in a future year to compensate for current work. Just to name a few examples, Section 409a can apply to:
- Supplemental executive retirement plans (also known as SERPs).
- Restricted stock.
- Stock options (if the exercise price is lower than the share price at the time the options were issued).
- Long-term commission programs.
- Severance agreements.
That holds true unless certain requirements are met, which I'll outline shortly, Section 409a states that amounts deferred under a nonqualified deferred compensation plan are subject to an additional 20% federal income tax penalty.
While the actual regulations established by Section 409a are rather lengthy and complicated (65 pages if printed out), the main idea is relatively simple, as we'll see in a second.
What does Section 409a do?
The main function of Section 409a is to govern the timing of when deferred compensation can be paid. In part, Section 409a was created in response to executives from Enron, Worldcom, and other companies who decided to accelerate their deferred compensation payments in order to "cash out" before the company went bankrupt.
Specifically, Section 409a establishes six instances when it's acceptable to distribute money from a nonqualified deferred compensation plan:
- When the employee separates from service.
- When the employee becomes disabled.
- Upon the death of the employee.
- At a fixed time or on a schedule specified by the plan's documents.
- Upon a change in ownership or control of the company.
- In the event of an unforeseen emergency.
It's also worth noting that for "key employees" of publicly traded companies, there is an additional six-month delay after separation from service before nonqualified deferred compensation can be distributed.
For a nonqualified deferred compensation plan to be in compliance with Section 409a, there must be a written plan document as well as documents that specify how much compensation will be deferred and when the payment will be made. And, payment must be made in a timely manner in accordance with the conditions of the plan.
And, the decision to defer the compensation in the first place must be made before the money is legally owed to the employee. In general, this means the election to defer must be made before the start of the year in which the compensation will be earned. For example, if I choose to defer bonuses that I would be entitled to in 2016 until a later, predetermined year, I would need to make that election by Dec. 31, 2015.
I briefly mentioned stock options earlier, but since it is a common trigger for Section 409a, it's worth mentioning again. Stock options are generally treated as nonqualified deferred compensation if the options' exercise price is lower than the stock's price at the time the options are given as compensation.
For example, let's say that your company's stock is trading for $50 a share, and as a result of your excellent performance, your company has decided to grant you stock options to purchase 1,000 shares at $40 at any time over the next couple of years -- so the options are "in the money" by $10 per share on the day you get them. Well, the $10,000 of intrinsic value those options have can be treated as nonqualified deferred compensation under Section 409a, and could result in extra tax liability.
On the other hand, if the same company chooses to reward its employees by issuing out-of-the-money options with a strike price of, say, $60, expiring at some point in the future, it would not be considered deferred compensation, since the options don't have any intrinsic value.
The bottom line
As long as the timing and other requirements specified in Section 409a are met, the additional tax penalty doesn't apply. However, if you are the recipient of deferred compensation that does not meet the requirements; you could find yourself with an unexpectedly large tax bill.