Few tax code sections are as technical or punitive as Section 409A. If you get things wrong, you’re staring a 20% penalty in the face… plus acceleration of tax, plus interest, plus an additional 5% penalty if you happen to live in California.
But there is good news. Section 409A does not apply to everything. It only applies to a legally binding right to nonqualified deferred compensation.
Lesson over. Now it’s time to test your knowledge.
Hypothetical 1
A company’s CEO is really impressed with a new hire and takes her aside and says, “If you work really hard this year, I’ll try to give you a sweet bonus next year.”
Does Section 409A apply?
No. Section 409A only applies to a legally binding right to nonqualified deferred compensation. Here, there is no legally binding right because the promise is too vague.
Hypothetical 2
A company has a 401(k) plan. Tax is deferred until future distributions are made.
Does Section 409A apply?
No. Section 409A only applies to a legally binding right to nonqualified deferred compensation and a 401(k) plan is a qualified plan.
Hypothetical 3
A company surprises employees at a lunch picnic by handing out large bonuses.
Does Section 409A apply?
No. Section 409A only applies to a legally binding right to nonqualified deferred compensation, i.e., compensation that may be paid in a future tax year.
As an aside, all of the following are not subject to Section 409A, because they are not considered deferred compensation:
- Restricted stock, capital interests, and profits interests;
- Incentive stock options;
- Certain fair market value nonstatutory stock options and stock appreciation rights; and
- Restricted stock units (RSUs) as long as they are settled as they vest.
Hypothetical 4
A supplier delivers 300 widgets to a company on April 15, 2019. The company promises in writing to pay the supplier for the widgets in exactly one year.
Does Section 409A apply?
No. Section 409A only applies to a legally binding right to nonqualified deferred compensation and the cash exchanging hands to pay for the widgets is purchase price, not compensation.
Hypothetical 5
You and a co-founder agree to defer a portion of your salaries until some future date. The company has sufficient funds to pay you, but you’d prefer to reinvest everything into the business. The board agrees and you each sign a one-page amendment to your employment agreement specifying how the accrual will be calculated and that the company can choose to pay you at a financing, or at any earlier time, in the board’s sole discretion. You only accrue additional amounts while employed, but you can quit and retain your right to be paid in the future the amount that accrued prior to your resignation.
Does Section 409A apply?
Yes. This is a legally binding right to nonqualified deferred compensation. And unfortunately, the board’s discretion to accelerate the payment violates Section 409A, so the deferred compensation will be subject to the applicable penalties and will be taxable as it accrues, rather than when it is paid.
For example, someone who lives in California and is subject to the top marginal rate, would have to pay 77.65% of the accrued salary to the government (37% federal income tax + 20% federal tax penalty + 1.45% Medicare + .9% Additional Medicare + 13.3% California state tax + 5% California tax penalty). And this tax would be due before the accrued salary is even paid!
Just because compensation is subject to Section 409A however, does not mean that the penalties apply. It is possible to structure compensation that is subject to Section 409A in a way that complies with Section 409A. In the above example, if the accrued salary could only payout upon the closing of a financing, and in particular if it would only payout at all if such event occurred within say 5 years of the date of the employment agreement amendment, then tax could have been deferred until the date of payment and no penalty would have been due.
The saying “an ounce of prevention is worth a pound of cure” comes to mind here. Agreements worth having tax counsel review include:
- Offer letters;
- Employment agreements;
- Separation agreements;
- Deferred compensation agreements (or emails from the CEO);
- Bonus plans or awards;
- Equity incentive plans;
- Phantom equity; and
- Carve-out plans.
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.