By now, you are very likely at least somewhat familiar with Internal Revenue Code Section 409A. This section was added as part of the American Jobs Creation Act of 2004 and imposes various strict requirements, briefly summarized below, on non-qualified deferred compensation plans. Under IRS Notice 2007-78, most plans must be amended on or before December 31, 2008 to conform to the technical requirements of, and final regulations under, Section 409A.

The penalty for not complying with the requirements is severe. Compliant plans allow for the recipient to be taxed on the income related to the deferral at the time payment is received in a subsequent year. (This allows the tax burden to be deferred until the recipient can pay the tax using the proceeds that incurred it – a logical outcome.) With few exceptions, noncompliant plans force the recipient to pay tax on the deferred income currently – possibly years before the deferred payments are received! Notice 2007-78 allows plans that otherwise would produce this unfavorable mismatch to be amended by the end of this year without penalty. Failure to timely amend a plan that needs it can result in immediate acceleration of the income as described above, in addition to interest and a 20% penalty.

Section 409A applies, with a few exceptions, to all plans and agreements that give a service provider a legally binding right to compensation that will or may be paid in a later year. Its scope is very broad and can include, among other things, supplemental deferred compensation agreements, bonus arrangements, stock option plans and stock appreciation rights. The requirements can apply to oral as well as written agreements, and to independent contractors as well as employees.

Some of the exceptions (i.e., situations where Section 409A does not apply) include:

• Qualified retirement plans;
• Bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans;
• Compensation that was granted and vested before 2005 with no material modifications after October 3, 2004; and
• Agreements that provide that payments must be made within a short-term deferral period, generally 2 ½ months after year end.

In general, some of the restrictions of 409A are as follows:

• Elections to defer compensation must be made on or before December 31 of the preceding year.
• Plan distributions are permitted only at a time specified in the agreement or upon one of certain specified events, including death, disability, separation from service, change in ownership or control or an unforeseeable emergency.
• The ability to alter the timing of distribution is extremely limited. Elections to amend must take place at least 12 months before the first scheduled payment, and distributions must be delayed for at least 5 years.

Section 409A contains very strict and specific definitions of certain terms, such as disability, separation from service and change of control.

You should act as soon as possible to ensure that all of your compensation arrangements comply with Section 409A. First, you should review all of your plans and agreements to see if they give a service provider a legally binding right to compensation that will or may be paid in a later year. Second, you should see if any of the exceptions apply. Third, you should make sure that the requirements of Section 409A are met. Finally, you ensure that the language of your plan documents is in full compliance with the provisions of 409A.

This article is provided for information purposes only and should not be relied upon for legal or financial advice. For more details about this matter, please contact Drew Cheney or another BNN tax professional at 800.244.7444.

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