Employers seeking to defer part of an employee’s compensation to a later year must beware of Section 409A of the Internal Revenue Code. That section imposes strict requirements when an employee obtains a contractual right to compensation in one year (without a substantial risk of forfeiture) but does not receive that compensation until a later year. Unless those requirements are satisfied, deferred compensation can be fully taxable to the employee in the year in which it is earned, rather than the year in which it is paid, and the employee can face substantial penalties.
Subject to some exceptions, Section 409A’s general rules regarding deferred compensation are: (1) the initial decision to defer compensation must be made before the year in which the services are performed; (2) changes to that decision are restricted; (3) the deferral agreement or plan must be in writing; (4) the deferral payments must be made on a fixed schedule; and (5) acceleration of the payments is prohibited. Employers contemplating any deferral of compensation should consult with tax counsel regarding Section 409A.