409A

Get Informed Now to Avoid Penalties

Payments under a non-qualified deferred compensation plan that is not in compliance with IRC section 409A can result in a penalty of 20% of the compensation plus an acceleration of the tax and interest. This provision of the Internal Revenue Code is very broad and complex. One way to avoid this provision is to take advantage of the short-term deferral exception. Under this exception, payments made within 2 1/2 months after the later of the employee's taxable year or the employer's taxable year in which the deferred compensation is no longer subject to a substantial risk of forfeiture are not subject to 409A. However, a payment under a plan that provides for a deferred payment that either will or may be paid after the end of the 2 1/2 month period (e.g., a payment that is payable upon separation from service) will not qualify for the short-term deferral exception, even if payment is made by the end of the 2 1/2 month period. 

In the case of a year-end bonus, it is advisable to take the following steps:

1. Remember to pay a bonus by the 15th day of the 3rd month after the close of the employee's tax year. However, where the employer's tax year (e.g., 9/30/07) precedes the employee's tax year (12/31/07), it would be necessary to pay the bonus by the 15th day of the 3rd month following the employer's tax year (i.e., 12/15/07 in the case of a 9/30 year-end) in order for an accrual basis employer to deduct the bonus in the current tax year (subject to the exception for certain majority shareholders). 
2. The bonus award should be reflected in writing as of the date the employee is notified of the award. The written bonus award should indicate the date the bonus is awarded and the date it will be paid. Be sure to exclude any payment event (e.g., separation from service) that may result in a bonus paid after the 2 1/2 month period. 
3. Properly drafted, the bonus plan will be exempted from section 409A under the short-term deferral rules. 
4. As these rules are complex, it is recommended that you review your plan with a qualified professional prior to the end of the year. 
5. Finally, recently issued regulations under 409A require written documentation for all non-qualified deferred compensation plans that are subject to 409A by December 31, 2007. Failure to comply with these rules could result in severe penalties to employees covered under the plan. 

Calculating Section 409A Penalties

Section 409A covers inclusion in gross income of deferred compensation plans and a failure to comply can lead to some rather harsh consequences to the service provider (employee or independent contractor). A discussion of proposed regulations tells us how deferred compensation is calculated, how it is allocated and how interest is calculated for such prior years, and related matters.

Jon Chapman, a tax partner with Feeley & Driscoll, P.C., has released additional material on the subject matter:

409A Regulations; Basic Requirements (November / December 2007)

409A Proposed Regulations; Calculating the Penalties (May / June 2009)

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