Royal Financial

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Deferred compensation plans are an important tool employers use to attract and retain talent. They allow employees to earn compensation today but receive it later — often at retirement, separation, or another milestone. But with this flexibility comes significant complexity, especially for nonqualified deferred compensation (NQDC) plans.

Enter IRC §409A, enacted in 2004 after the Enron scandal, to crack down on abusive deferred compensation practices. If your company offers NQDC plans (e.g. discriminatory plans), understanding and complying with §409A is essential to avoid steep tax penalties for your employees.

In this post, we’ll break down what §409A covers, who it applies to, what rules must be followed, and what happens if you don’t comply.

What is Deferred Compensation?

Deferred compensation is any pay earned by an employee today but paid out in a future year.

• Qualified plans (like 401(k)s) meet IRS requirements, giving employers immediate deductions and employees tax-deferred income.
• Nonqualified plans don’t meet those requirements. They’re more flexible but come with more restrictions — and are subject to §409A.

Examples of nonqualified deferred compensation:

• Executive bonus deferral plans
• Severance arrangements
• Salary deferrals
• Nonqualifed stock options or SARs (if improperly structured)

Who Does §409A Apply To?

• U.S. employees, even if working abroad
• Some independent contractors
• Nonqualified deferred compensation recipients subject to U.S. tax

Exceptions

409A doesn’t apply to:

1. Qualified pension, profit-sharing (401(k)), stock bonus plans (§401(a) and §403(a)), tax-sheltered annuities and custodial accounts (§403(b)), simplified employee pensions (§408(k)), SIMPLE retirement accounts (§408(p)), and eligible deferred compensation plans (§457(b)).
2. Short-term deferrals which are those paid within 2.5 months of vesting assuming there are no plan provisions that would allow payment to be made at a later date. Note, this is the most common exception. Furthermore, there are cases where payment can be deferred, but its must be due to administrative reasons or going-concern reasons.
3. Welfare benefit plans, including medical, vacation, sick leave, disability, archer, medical savings accounts, health savings accounts, and death benefit plans, are exempt from 409A.
4. Payments for involuntary separation( Reg. §1.409A-1(b)(9)(iii)) as long as they meet BOTH the requirements below:
   • #1 Payments do not exceed twice the lesser of:
     • the employee’s annualized rate of compensation for the preceding taxable year OR
     • an IRS threshold (the 401(a)(17) compensation limit) which is $350,000 in 2025 (up from $345,000 in 2024).
   • #2 Payments are completed by the end of the second calendar year after the year in which the service provider separates from service.
5. Certain Stock options and appreciation rights. For example, the grant of an ISO or an option under an ESPP is NOT a deferral of compensation.
6. A transfer of property in connection with the performance of services, taxable under §83, does NOT result in deferred compensation, regardless of whether the property is subject to a substantial risk of forfeiture. This exclusion from the provisions of §409A has made restricted stock a more attractive form of compensation.

Making the Election

Employees must make irrevocable election to defer compensation before the year services are performed. The election must specify the time and form of payment & must be documented in writing.

Distributions

Plans can only distribute deferred compensation upon the below items. Employees generally cannot accelerate payment of deferred compensation (with narrow exceptions).

1. Separation of service
2. Death
3. Disability
4. Change in control of the business
5. Unforeseeable emergency
6. A specified date or fixed schedule

Failing to Follow Rules

If a 409A plan rules are not complied with, all the compensation deferred under the plan for the taxable year and all preceding taxable years is includible in gross income. (§409A(a)(1)(A)(i)(II)). The amount of the deferred compensation included is subject to:

1. Regular income tax
2. 20% Additional tax
3. Premium interest penalty

Special Considerations

• Specified Employees of Public Companies: Must wait six months after separation to receive payments.
• Substantial Risk of Forfeiture: A key concept that delays taxation — but note the definition in §409A differs from §83.
• Short-Term Deferral Exception: No deferral exists if payment is made within 2½ months of the year the employee vests.

Conclusion

IRC §409A fundamentally reshaped the landscape of deferred compensation. While its rules are complex, they’re manageable with careful planning and administration. If your company offers NQDC plans, make sure you understand these rules and stay compliant — your employees will thank you.

Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.