Section 409A governs how nonqualified deferred compensation must be designed, documented, and paid — and the penalties for getting it wrong fall on the executive, not just the company. Understanding where plans go wrong, and how the IRS correction program works, can mean the difference between a minor fix and a major tax event.
Why 409A Exists: The Enron Origin Story
In 2003, the House Ways and Means Committee proposed a bill that effectively “eliminated” the possibility of deferred compensation — all because executives at Enron had “swapped” future compensation for a life insurance benefit placed outside the reach of both individual and company creditors. With approval from a board that did not know the company was failing, they accelerated their payments before the collapse came to light. In response, Congress created IRC 409A, the rules that now govern deferred compensation — and the corrections required when those rules are broken.
Fast forward to today: under IRC 409A, specific rules and guidelines are defined to prevent what occurred in 2003. The law requires a company to define numerous items as part of the deferred compensation plan at the time the plan is established. The plan document outlines the responsibilities of both employer and employee — including when and how compensation is earned and paid (two very different things for tax purposes, depending on the tax structure of the company) — and defines all of the terms of the plan.
The History of Enron and Its Ramifications
What the Plan Document Must Define
A list of items defined in the plan document or its addendum should include, but is not limited to, the following:
- Plan Date
- Effective Date
- Payment Dates
- Who can defer — Employer: Is it discretionary? Is it a match? Employee: How much can be deferred (Base Salary, Bonus, Performance-Based Comp?)
- When can you defer
- When you can take a payment
- How you can take a payment — Lump Sum? Equal Payments (3-5-10 years)?
- When can it be re-deferred
- Penalties
This level of detail is precisely why disciplined plan design matters so much — a theme we explore in why NQDCs are indispensable and across both 401(k) Mirror Plan structures.
Common Section 409A Compliance Errors
Companies tend to make a number of errors when it comes to Section 409A compliance, including:
- Incorrect calculation of plan deferrals and distributions
- Failure to make deferral or distribution elections in a timely manner
- Failure to comply with Section 409A definitions for specified terms
- Early payment of an amount payable in a later year
- Late payment of an amount payable in an earlier year
The Penalties Are Severe
Unfortunately, with errors come significant penalties, including:
- Immediate income recognition of the participant’s entire plan balance (the “taxable amount”) with respect to the year of the error
- Potential late payment penalties and interest on the taxable amount
- An additional 20 percent excise tax and “premium interest tax” on the taxable amount
- Potential late penalties and interest on failure to withhold
- Restating and refiling previous years’ tax forms (e.g., Forms W-2 and 1099 for companies and Form 1040 for plan participants)
Note that these penalties land primarily on the participant — the executive — which is why careful administration of every deferred compensation arrangement, including those at not-for-profits, is so important.
The 409A Correction Program
The good news: if the plan sponsor catches an error within two years of it occurring, the IRS has a voluntary correction program that can help you avoid sizeable taxes and penalties. Relief is subject to the size of the company, the size of the plan, and whether the failure was willful (and whether it was found by the IRS rather than self-reported).
More information on the IRC 409A Correction Program can be found here: IRS Notice 2010-06 (PDF).
Related Resources
- 409A Nonqualified Deferred Compensation Plans: Compliance, Design, and Strategy
- Deferred Compensation Plans: A Complete Guide to NQDC for Business Owners
- Strategic Discipline: Why NQDCs Are Indispensable
- The 401(k) Mirror Plan: Employee-Funded NQDC
- Deferred Compensation in Not-for-Profits: 457(b), 457(f), and the $1M Excise Tax
Concerned About a 409A Issue?
If you suspect your plan may have a compliance gap, the worst thing you can do is wait — the correction window is narrow. Let’s review your plan together and map the right path forward.
** This information is provided with the intent of educating the public. It is not intended to be all-encompassing and may or may not apply to your specific plan. Please contact your accountant or attorney to determine whether this is applicable to you and your company.