Understanding Internal Revenue Code Section 409a can be a challenge, to say the least. It’s a relatively complicated yet widespread aspect of our tax accounting system that is especially important when handling layoffs.

What is Section 409a?

In brief, Section 409a refers to deferred compensation for work performed. It can apply to SERPs, restricted stock, stock options, long-term commission programs, and severance agreements.

What does Section 409a do?

According to The Motley Fool, “The main function of Section 409a is to govern the timing of when deferred compensation can be paid. In part, Section 409a was created in response to executives from Enron, Worldcom, and other companies who decided to accelerate their deferred compensation payments in order to “cash-out” before the company went bankrupt.”

Put more specifically, Section 409a outlines six instances when it is acceptable for employers to distribute money from a nonqualified deferred compensation plan:

  1.   When the employee separates from the employer
  2.   When the employee becomes disabled
  3.   The employee passes away
  4.   At a fixed time or on a schedule specified by the plan’s documents.
  5.   Upon a change in ownership or control of the company.
  6.   In the event of an unforeseen emergency. 

For a nonqualified deferred compensation plan 409a compliant, the employer has to have a written document that details the plan and documents that specify how much compensation can be deferred and when the payments can be paid. 

And, the decision to defer the compensation in the first place must be made before the money is legally owed to the employee. In general, this means the election to defer must be made before the start of the year in which the compensation will be earned. 

What Are The Tax Implications?

As long as the timing and other requirements specified in Section 409a are met, the additional tax penalty doesn’t apply. However, if you are the recipient of deferred compensation that does not meet the requirements; you could find yourself with an unexpectedly large tax bill.