Following the Enron scandal in the early 2000s, the U.S. Internal Revenue Code (“IRC” or “Code”) was amended to include Section 409A (“IRC 409A”), which broadly regulates deferred compensation arrangements. Given that failure to comply with IRC 409A can result in devastating tax penalties, it’s essential that company management teams are familiar with these regulations and understand the situations in which they may apply.
Overview of IRC 409A
Prior to its collapse, unscrupulous Enron executives accelerated the receipt of approximately $32 million from deferred compensation arrangements and funneled them into limited partnerships in a bid to shield the funds from creditors. When Enron later declared bankruptcy, it was the company’s employees that bore the brunt of the company’s equity wipeout. While technically the executives’ actions were not illegal at the time, the optics of Enron executives emerging relatively unscathed while the 401(k) accounts of thousands of employees went up in smoke led to Congress and the U.S. Internal Revenue Service (“IRS”) introducing IRC 409A in January 2005 as part of the American Jobs Creation Act of 2004.
IRC 409A was established to regulate situations in which there is a “deferral of compensation,” which occurs when an employee receives a legal right during a certain tax year for compensation that is payable in a subsequent tax year. Through this regulatory framework, the IRS can restrict the ability of beneficiaries of deferred compensation arrangements to defer or accelerate payments from those plans as well as their ability to design or modify deferred compensation arrangements. The IRS is particularly concerned with non-qualified deferred compensation (“NQDC”), which it defines broadly. Examples of the deferred compensation arrangements for which IRC 409A may apply, as well as arrangements specifically excluded by these rules, are provided below:
Applicable Arrangements: Non-qualified retirement plans, severance and separation programs, post-employment payments, reimbursement arrangements, elective deferrals of compensation, stock options, other equity incentive plans, and a variety of other deferred compensation arrangements.
Exclusions: Tax-qualified retirement plans, non-taxable benefits such as the reimbursement of health insurance premiums, vacation and sick leave, short-term disability compensation, death benefit plans, short-term deferrals in which the full amount will be paid within two-and-one-half months following the end of the recipient’s tax year, incentive stock options (“ISOs”), employee stock purchase plans (“ESPP”) covered by Section 423 of the IRC, non-deferred grants of equity even if subject to vesting, non-qualified stock options with an exercise price greater than or equal to fair market value of the underlying security as of the grant date, certain involuntary severance programs (subject to certain timing and dollar thresholds), and certain plans established for foreign employees.
Penalties
IRC 409A stipulates certain documentation and operational requirements that must be followed by companies with deferred compensation plans. The IRS may assert a documentary violation has occurred if a compensation arrangement includes provisions that are inconsistent with IRC 409A rules and/or an operational violation has occurred if an action is taken concerning the payment of deferred compensation that violates the IRC 409A rules. Typically, a documentary failure will result in the application of penalties to all participants of the subject deferred compensation arrangement while an operational failure on the part of a particular plan participant will result in penalties on just that participant. However, in the event of an operational failure, the IRS can enforce a sweeping aggregation rule in which it will also apply penalties to all plans of similar type attributed to the participant, even if the other plans are compliant. Thus, a participant’s operational violation with respect to just one component of their deferred compensation can result in quickly escalating penalties.
If a company fails to comply with the appropriate compensation rules, the IRS leverages tax and interest penalties on the employee rather than the company itself. In the event the IRS determines a company to be in violation of IRC 409A, the NQDC awarded to an employee is immediately and fully taxable regardless of physical receipt by the employee. Second, an additional twenty percent excise tax penalty is imposed on the value of the NQDC required to be included in gross income. There’s also an interest charge that will apply based on the federal underpayments rate plus one percent beginning in the year in which compensation was first deferred. If all of that wasn’t bad enough, employees with stock options awarded by a non-compliant NQDC plan will also need to pay taxes on the change in the intrinsic value of the stock options in each tax year until the options are exercised. To better illuminate just how expensive these penalties can be, the U.S. Securities and Exchange Commission has published a hypothetical example here.
Conclusion
While IRC 409A was originally introduced to address executive abuses of deferred compensation arrangements, it has resulted in a heavy, high-stakes burden on companies to ensure that deferred compensation arrangements established on behalf of their employees are compliant. Given the sizeable penalties that can be levied by the IRS, it is critical for companies with deferred compensation plans to understand the scope and ramifications of IRC 409A. If your company has already issued, or is thinking about issuing, deferred compensation via common stock options to your employees, we recommend you read our follow-up article, “Protect Your Stock Options with these 409A Safe Harbor Rules.”
