Section 409A imposes complex restrictions on almost every aspect of “nonqualified deferred compensation” arrangements. Under Section 409A, an arrangement provides “nonqualified deferred compensation” if, under the terms of the arrangement, an employee acquires in one year a legally binding right to receive compensation that will or could be paid in a later year.  The definition of “nonqualified deferred compensation” is very broad and the following types of arrangements typically fall within the scope of Section 409A:  

(i) deferred compensation plans (such as salary and bonus deferral programs); (ii) supplemental retirement plans; (iii) severance plans; (iv) annual or multi-year incentive bonus arrangements; (v) employment agreements that provide for severance, change in control or other deferred payments; (vi) discounted stock options and certain stock appreciation rights; (vii) change in control agreements; (viii) phantom stock plans; and (ix) restricted stock unit agreements.

If an arrangement violates Section 409A, the employee is required to include in income all amounts deferred or subject to the arrangement (regardless of whether the employee is entitled to receive a payment in that year).  In addition, the employee must pay an additional 20% tax (over and above the regular federal income tax already owed) and interest penalties.  These penalties apply not only to the arrangement that violates Section 409A, but also to any other similar arrangement between the employer and the same employee.

Due to the broad reach of Section 409A, the first challenge facing an employer is simply to identify all of its nonqualified deferred compensation arrangements (i.e., those arrangements that provide an employee with a legally binding right to receive a payment in a future year).  An employer needs to analyze the arrangements to determine whether a Section 409A violation has occurred.  In our experience, some common 409A violations include but are not limited to: (i) ambiguous payment provisions such as “as soon as reasonable practicable” or ambiguous payment triggers such as “termination of employment;” (ii) an impermissible definition of “separation from service,” “change in control event,” or “disability;” (iii)  a private company’s grant of stock options with an exercise price that is less than “fair market value” as determined in accordance with Section 409A; (iv) a definition of “good reason” that prevents the use of the short-term deferral or separation pay exceptions to Section 409A; and (v) the failure to include the so-called “two year rule” for a payment of nonqualified deferred compensation that is conditioned on the execution of a release agreement.

Reviewing deferred compensation arrangements for compliance with Section 409A provides an opportunity to correct eligible failures through the Section 409A correction programs and to minimize or avoid the Section 409A penalties that may be imposed on employees.