Section 409A of the Internal Revenue Code regulates the treatment for federal income tax purposes in the United States of nonqualified deferred compensation paid by a "service recipient" to a "service provider". Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, as well as entities that provide services (an LLC, for example, could be a service provider).
Contents
History
Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine.
Basic summary
Section 409A generally provides that "non-qualified deferred compensation" must comply with various rules regarding the timing of deferrals and distributions. Under regulations issued by the IRS, Section 409A applies whenever there is a “deferral of compensation,” which occurs whenever an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or death benefit plan. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.
Qualified and non-qualified deferred compensation
Section 409A makes a distinction between deferred compensation plans and deferral of compensation. The term "plan" includes any agreement, method, program, or other arrangement, including an agreement, method, program, or other arrangement that applies to one person or individual.
Section 409A specifies that unless any deferred compensation falls into a specified set of "qualified deferred compensation" categories, the IRS will automatically consider it unqualified deferred compensation. The qualified deferred compensation categories are:
Timing restrictions
Section 409A’s timing restrictions fall into three main categories:
1) restrictions on the timing of distributions;
2) restrictions against the acceleration of benefits; and
3) restrictions on the timing of deferral elections.
Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances:
1) the employee’s separation from service;
2) the employee's becoming disabled;
3) the employee's death;
4) a fixed time or schedule specified under the plan;
5) a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation; or
6) the occurrence of an unforeseeable emergency.
In addition, Section 409A provides that with respect to certain “key employees” of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier.) Key employees are generally the top 50 employees with pay above $150,000.
The rules restricting the timing of elections as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories:
(1) initial deferral elections; and
(2) subsequent deferral elections.
As a general rule, initial deferral elections must be made no later than the close of the employee's taxable year immediately preceding the service year. The term “initial deferral elections” includes all decisions, whether made by the employee or employer, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections.
Penalties
Section 409A assigns compliance-failure penalties to the recipient of deferred compensation (the "service provider") and not to the company offering the compensation (the "service recipient"). The sanctions for non-compliance can be severe. The specific penalties written into law are:
Impact on privately-held companies
One area of concern in early drafts of 409A was the impact on companies with stock that is not readily tradeable on an established securities market and these companies' employees. As of 2014, approximately 8.5 million American workers held stock options. Since options often vest and become taxable more than 1 year after they are granted, it would seem that 409A would apply to this as a form of deferred compensation. However, 409A specifically does not apply to incentive stock options (ISOs) and non-qualified stock options (NSOs) granted at fair market value. However, if a company issues options to a service provider at a valuation below fair market value, section 409A will apply. The fair market value of an option on common stock is defined as the fair market value of the common stock (the underlying security) on the date of issuance. Therefore, the valuation of common stock is critical.
Anticipating this problem, those drafting the regulations created a set of valuation standards for companies. The code provided a way for companies to achieve a safe-harbor valuation. A safe-harbor valuation is one where the IRS must accept the valuation as valid unless the IRS can demonstrate that the valuation is "grossly unreasonable." The code provides three possible ways for companies to achieve a safe-harbor valuation of their common stock:
The code defines "stock of illiquid startup companies" as stock of a corporation that meets the following criteria:
Industry commentators pushed for specific guidelines regarding the definition of a "qualified individual" who could perform the valuation for an illiquid startup. The final regulations did not provide specific examples of the qualifications necessary to perform a 409A valuation for an illiquid startup, highlighting that the requisite experience "could be obtained in many ways." However, the final regulations clarified that:
Given the small budgets of illiquid startups, many industry participants (including companies and their investors) became frustrated by the need to pay for potentially costly valuations by independent valuation firms. Some valuations could initially cost $50,000, a sum that most startups could never pay. However, recent 409A valuation prices for startup companies have decreased to $1,500 to $5,000 depending on the stage of the company receiving the valuation. For pre-IPO companies and very late-stage companies the prices can be significantly higher as the need for more frequent valuations increases.
Criticisms of IRC 409A
Industry commentators have had ongoing concerns with Section 409A. From its announcement and finalization, the IRS itself has recognized that many industry commentators have expressed concerns about the complexity and reasonableness of several aspects of the law. Particular criticisms have included: