409(A) Deferred Compensation

Deferring compensation is commonly used to avoid paying taxes on compensation immediately. But, under the Internal Revenue Code (IRC), deferring compensation can sometimes cause additional taxation. As a result, individuals and businesses considering deferring compensation should understand the scenarios that may trigger this tax.

Deferred Compensation

Deferred compensation is compensation paid in a year other than the year it was actually earned. Often, this is used to defer the payment of tax on that income until a time in which the taxpayer will be taxed more favorably.

IRC Section 409A places certain limitations on what compensation can be deferred. A failure to meet the requirements of Section 409A initiates an additional 20 percent income tax, and causes tax to be due on compensation when earned. But as long as the requirements of Section 409A are met, there is no impact on the employee’s taxes. In other words, the income is treated the same as if it were not covered by the provisions of Section 409A.

Under Section 409A, amounts deferred under a “nonqualified deferred compensation plan” are currently taxed as soon as they are not subject to a “substantial risk of forfeiture,” unless the plan complies with highly specific requirements as to the payment’s timing, funding, and other features. Failure to comply with these specific requirements can trigger the additional 20% income taxation and end deferral. Nonqualified deferred compensation is virtually any method or arrangement under which an employee earns a legally binding right to compensation in one year, but does not receive the income until a later year. A substantial risk of forfeiture exists if a person’s rights to compensation are conditioned upon the future performance of substantial future services.

Section 409A applies to many compensation plans, including bonus plans, plans paid with equity or property, and more.

Section 409A does not have an impact on FICA (Social Security and Medicare) tax.

Working Part of the Year

It is important to note that employees who work for part of the year, such as teachers, but that are paid over an entire 12-month period, fall under the provisions of Section 409A. The IRS considers this arrangement as deferring compensation from one year to the next. However, regulations provide an election regarding such employees to avoid Section 409A, so long as the employees defer no income for more than 13 months and the election is made before the employee begins their yearly services.

Help Understanding 409A Applicability

Section 409A is very complicated, but can have significant consequences. If you would like more information about deferred compensation or other tax-related matters, speak with an experienced attorney at the Royse Law Firm. As one of the premier tax boutique law firms in the Bay area, we frequently advise on the applicability of Section 409A. We look forward to hearing from you and discussing how we can use our knowledge and expertise to help.

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Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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