Internal Revenue Code Section 409A was enacted as part of the American Jobs Creation Act of 2004. It contains specific rules that certain NQDC plans must meet to avoid serious adverse tax consequences for individuals participating in those plans. In general, Section 409A applies to compensation deferred after December 31, 2004.
Which Plans Must Comply with Section 409A?
Section 409A applies broadly to any plan that defers the receipt of compensation from one year to a future year. It applies to typical NQDC plans like top-hat plans, supplemental executive retirement plans (SERPs), and excess benefit plans, and also to certain plans not typically thought of as NQDC plans, like severance arrangements. It can also apply to certain stock-based arrangements like phantom stock plans, stock appreciation rights (SARs), and nonqualified stock options.
The term “plan” includes any agreement or arrangement, including those that cover only a single person, including employees, directors, and independent contractors.
Are Any Plans Exempt?
Yes. Section 409A does not apply to qualified plans, 403(b) plans, SIMPLE IRAs, SEPs, 457(b) plans, or bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans.
Importantly, Section 409A also does not apply to any plan that pays out all benefits within 2½ months after the end of the year in which the participant’s benefits vest.
What does Section 409A Require?
Section 409A sets out specific rules governing NQDC plan deferral elections, distributions, and funding:
- In general, elections to defer compensation must be made before the start of the year in which the compensation is earned. The initial deferral election must also specify the time the deferred compensation will be paid and the form of payment. Special rules apply to performance-based compensation. Elections can be changed only if specific conditions are met.
- Distributions can be made from a NQDC plan only upon separation from service, death, disability, change in control of a corporation, unforeseeable emergency, or at a specified time or pursuant to a fixed schedule.
- Section 409A generally prohibits a NQDC plan from holding offshore investments. And plans can’t contain a provision that requires funding in the event of a change in the employer’s financial condition.
What Happens if Section 409A is Violated?
Affected participants will have serious adverse tax consequences. All vested accrued benefits become immediately subject to federal income tax. The taxable amount is also subject to a 20% penalty and interest charges.
If you have questions, contact the Experts at Henssler Financial:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.