Section 409A is a highly technical section of the tax code that slaps a 20% tax penalty onto improperly structured deferred compensation. But there is a hack. You can avoid the penalty by adding these 10 magic words to the contract…
“, subject to [his/her] continuous service as of the payment date.”
Why does this work? Section 409A only governs deferred compensation. If continuous service is required through the date of payment, the compensation is not considered to be deferred and thus is exempt from Section 409A.[1]
If you want a cheap solution, this is it.
There is a way to not require continuous service through the payment date but still avoid the penalty by complying with Section 409A.[2] Here the trick is to defer the compensation to the earlier of one or more of the following allowable events:
- A separation from service;
- Disability;
- Death;
- A fixed date;
- A change in control;
- An unforeseeable emergency; or
- The lapse of a substantial risk of forfeiture.
For example, to conserve cash, a company could allow a founder to defer a portion of his salary in 2020, with such deferred amount being paid to the founder upon a change in control of the company, regardless of whether the founder is still in service on such date.
There are however, complexities that arise when trying to structure compensation this way. For example, for employment tax reasons, you’ll likely want to put an expiration date on the arrangement. For instance, if a change in control does not occur within 10 years, the right to the deferred compensation vanishes.
The bottom line: You should always either use the 10 magic words, or have tax counsel review any contract that allows for someone to receive a payment after their service to the company has ended.
Mike Baker frequently advises with respect to tax code Section 409A. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Note, these 10 words need to be added when the right to the compensation is created.
[2] There are reasons why being exempt from Section 409A is preferable to being compliant with Section 409A, but either is sufficient to avoid the 20% tax penalty.