Internal revenue code section 409A: Overview, definition, and example
What is Internal Revenue Code Section 409A?
Internal revenue code (IRC) section 409A is a U.S. tax regulation that governs the taxation of nonqualified deferred compensation (NQDC) plans. It establishes rules to ensure that deferred compensation—such as stock options, bonuses, or retirement benefits—is structured properly to avoid immediate taxation and penalties.
For example, if an executive is promised a bonus payable in three years, Section 409A ensures that the arrangement follows specific timing and distribution rules to prevent unexpected tax consequences.
Why is Internal Revenue Code Section 409A important?
Section 409A is crucial because failing to comply with its requirements can result in severe tax penalties for employees or executives receiving deferred compensation. Key rules under Section 409A include:
- Timing of Elections: Employees must decide when to receive deferred compensation before earning it.
- Restrictions on Payouts: Payments can only be made at specific times, such as retirement, death, disability, or a pre-set date.
- No Early Withdrawals: Employees generally cannot accelerate payments before the agreed-upon date.
For employers, compliance with Section 409A ensures that deferred compensation plans do not trigger unintended tax liabilities or penalties for their employees.
Understanding Internal Revenue Code Section 409A through an example
Imagine a company offers its CEO a deferred bonus of $500,000, to be paid five years later. To comply with Section 409A:
- The CEO must elect the payment timing before earning the bonus.
- The company cannot accelerate or modify the payment unless it fits within Section 409A’s approved distribution events.
- If the company improperly modifies the agreement—such as paying the bonus early—the CEO could face an immediate tax bill on the full amount, plus a 20% penalty.
In another scenario, a startup grants stock options to employees. If the options are issued at a discounted price below fair market value without following 409A rules, employees could face immediate taxation and penalties, even if they haven’t exercised the options.
An example of an Internal Revenue Code Section 409A clause
Here’s how a section 409A compliance clause might appear in a contract:
“This Agreement is intended to comply with, or be exempt from, Section 409A of the Internal Revenue Code. All deferred compensation payments shall be made in accordance with Section 409A requirements, and no acceleration or modification of such payments shall occur except as permitted under applicable regulations. The Company makes no representation regarding the tax consequences of this Agreement, and the Employee is encouraged to seek independent tax advice.”
Conclusion
Internal revenue code section 409A regulates deferred compensation to prevent improper tax deferrals and penalties. Businesses must carefully structure deferred payments, stock options, and bonuses to ensure compliance.
By including a section 409A compliance clause in contracts, companies can protect employees from unexpected tax consequences while ensuring that compensation plans follow federal tax regulations.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.