The 409A Horror Show: Don’t Let Year-End Turn Into a Tax Nightmare

As year-end approaches, it is an opportune time for companies to run an internal audit of their nonqualified deferred compensation plans to flag any potential violations of IRC Section 409A (“Section 409A”).

Generally, the sooner a potential violation of Section 409A is identified, the more options a company has to correct the potential violation. 

The guidance provided by the IRS regarding correcting 409A failures provides additional flexibility if errors are corrected within the year in which they occur, which means that after December 31, 2025, it could be more difficult and more costly to fix a 409A failure that occurred in 2025.

The 409A Monster

The consequences of a violation of Section 409A can be quite significant, as follows:

• Immediate taxation of the non-compliant deferred compensation as of when the compensation vested, which could trigger late payment penalties and interest (including additional “premium” interest under 409A) depending on when the error occurred, was discovered and was corrected.
• A 20% penalty tax on the amount of taxable income with respect to which a 409A failure occurred.

Additionally, the employer may be subject to penalties and interest for failure to withhold, and both the employer and employee would have to restate and refile tax forms associated with the non-compliant deferred compensation.

Frights to Look Out for Before Year-End

Potential violations of Section 409A that sometimes occur, and that should be considered as part of an audit of a company’s nonqualified deferred compensation plans, equity compensation plans and employment agreements, are the following:

• Incorrect calculations of deferrals and distributions;
• Plans permitting compensation to be paid upon an event that is not a “permissible payment event” under Section 409A;
• Deferrals not made in accordance with elections or terms of governing documentation;
• Deferral elections not made in compliance with Section 409A;
• Failures to properly implement deferral elections;
• Stock options granted with an exercise price that is less than the fair market value of the underlying shares, as of the date of grant;
• Non-compliant definitions of terms, such as “separation from service” and “change in control”;
• Early (or accelerated) payment of compensation that was to be paid in a future year;
• Delayed payment of compensation that was to be paid in a prior year;
• Improper change of time and form of payment;
• Improper modifications, substitutions or extensions of stock rights; and
• Provisions in documents that improperly provide the employer or employee with the discretion to choose the year in which payment would be made (g., timing of severance payments tied to execution and non-revocation of release of claims).

Trick or (Tax) Treat?

Under the guidance provided by the IRS regarding correcting Section 409A failures, if certain failures are corrected in the same year in which they occurred, no penalty or tax would be due. However, if such failures are only discovered and corrected in the years following the year in which the error occurred, there could be taxes, penalties and interest incurred in connection with such an error.

Section 409a May Be Spooky, but It Doesn’t Have to Be a Nightmare

With year-end approaching, we recommend that companies review their deferred compensation plans and agreements, including equity plans, award agreements and employment agreements, with their counsel, as well as the operational processes associated with these arrangements, in order to flag any potential Section 409A issues or errors, in order to avail themselves of opportunities to resolve them in a timely manner.

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