As the year is quickly coming to an end, it is especially prudent to review compensation arrangements from an Internal Revenue Code section 409A perspective. Generally, Section 409A applies to “deferred compensation” arrangements between a “service recipient” and a “service provider.” The service recipient and service provider relationship may include the employer-employee relationship, and an employer’s relationship with its independent contractors.
Background. Section 409A’s impact can be very broad and all-encompassing. Effectively, any compensation arrangement where an employee (or other service provider) earns compensation by providing services to an employer in one taxable year, but is paid such compensation in a later taxable year, constitutes “deferred compensation” subject to Section 409A. Types of compensation arrangements that may be subject to Section 409A include (but are not be limited to) the following:
- Annual or other multi-year bonuses earned in one year (g., 2019), but will be paid in a later year (e.g. 2020 or later)
- Fringe Benefits provided by means of reimbursement of employee-incurred expenses if reimbursements occur in a later year than they were incurred
- Severance arrangements paid (including health benefits) in years later than the year in which the employee separated employment
- Non-qualified equity compensation plans that may provide for the grant of discounted equity (stock option plans, stock plans, phantom equity plans, etc.) with delayed vesting and exercise schedules
To be clear, “deferred compensation” arrangements are permitted under the Tax Code; however, such arrangements must be compliant with the complex rules underlying Section 409A. In general, an election to defer compensation must be made in the year prior to which the compensation is earned, it must be in writing, and such compensation may then only be payable on “permitted distribution events” (i.e., death, disability, a specific date, change in control event, and separation of service) or within the “short-term deferral period.” The “short-term deferral period” consists of the 21/2 month period following the end of the tax year in which an employee vests in compensation.
Section 409A Penalty. If subject to a Section 409A violation, the employee (or service provider) will be required to pay a current tax on any vested amounts of deferred compensation whether or not such compensation has been actually paid to the employee. Additionally, the employee will be subject to an additional tax equal to 20% of the applicable deferred compensation amount, plus another interest-based tax amount (i.e., underpayment tax). Deferred Compensation arrangements must be compliant from a documentary perspective as well as an operational perspective.
Not too late to correct potential issues Section 409A for 2019. Employers and employees should review their compensation arrangements – from a documentary and operational perspective – to determine if they may be paying “deferred compensation.” If employees earning their compensation in 2019 will be paid such compensation in 2020, then a deferred compensation arrangement may exist unless it is paid within the “short-term deferral period.” Employers and their employees should review these plans or consult with an attorney to ensure these arrangements are compliant with Section 409A. It is important for employees to review their compensation arrangements as well because the Section 409A penalty is assessed on the employee, and not the employer.
Additionally, employers and service recipients who intend to pay deferred compensation based on services being provided in 2020, (i.e., compensation earned during 2020 will be paid in 2021 or a later year), should make sure that such arrangements are compliant with Section 409A. As previously mentioned, elections to defer compensation must be in place in the tax year prior to the year in which the compensation is earned – this would mean that compensation being deferred on account of services performed during 2020 should generally be in place by the end of the 2019 tax year.
If you have any questions or need more information about IRC Section 409A, please contact Eric Loi, member of Flaster Greenberg’s Taxation and Employee Benefits & Executive Compensation Departments.