Internal Revenue Code section 409A

Last updated

Section 409A of the United States Internal Revenue Code regulates nonqualified deferred compensation paid by a "service recipient" to a "service provider" by generally imposing a 20% excise tax when certain design or operational rules contained in the section are violated. Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, as well as entities that provide services (an LLC, for example, could be a service provider).

Contents

History

Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching, because of the exceptionally broad definition of "deferral of compensation." Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine. [1]

Basic summary

Section 409A generally provides that "non-qualified deferred compensation" must comply with various rules regarding the timing of deferrals and distributions. Under regulations issued by the IRS, Section 409A applies whenever there is a "deferral of compensation," which occurs whenever an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or death benefit plan. Other exceptions include those for "short-term deferrals" (i.e. payments made within 2.5 months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans. [2]

Qualified and non-qualified deferred compensation

Section 409A makes a distinction between deferred compensation plans and deferral of compensation. The term "plan" includes any agreement, method, program, or other arrangement, including an agreement, method, program, or other arrangement that applies to one person or individual.

Section 409A specifies that unless any deferred compensation falls into a specified set of "qualified deferred compensation" categories, the IRS will automatically consider it unqualified deferred compensation. The qualified deferred compensation categories are:

Timing restrictions

Section 409A's timing restrictions fall into three main categories: [3]

Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances: [4]

In addition, Section 409A provides that with respect to certain "key employees" of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier). Key employees are generally the top 50 employees with pay above $150,000. [5]

The rules restricting the timing of elections as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories: [6]

As a general rule, initial deferral elections must be made no later than the close of the employee's taxable year immediately preceding the service year. The term "initial deferral elections" includes all decisions, whether made by the employee or employer, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections.

Penalties

Section 409A assigns compliance-failure penalties to the recipient of deferred compensation (the "service provider") and not to the company offering the compensation (the "service recipient"). The sanctions for non-compliance can be severe. [7] The specific penalties written into law [8] are:

Impact on privately-held companies

One area of concern in early drafts of 409A was the impact on companies with stock that is not readily tradeable on an established securities market and these companies' employees. As of 2014, approximately 8.5 million American workers held stock options. [9] Since options often vest and become taxable more than 1 year after they are granted, it would seem that 409A would apply to this as a form of deferred compensation. However, 409A specifically does not apply to incentive stock options (ISOs) and non-qualified stock options (NSOs) granted at fair market value. [10] However, if a company issues options to a service provider at a valuation below fair market value, section 409A will apply. The fair market value of an option on common stock is defined as the fair market value of the common stock (the underlying security) on the date of issuance. Therefore, the valuation of common stock is critical. [11]

Anticipating this problem, those drafting the regulations created a set of valuation standards for companies. The code provided a way for companies to achieve a safe-harbor valuation. A safe-harbor valuation is one where the IRS must accept the valuation as valid unless the IRS can demonstrate that the valuation is "grossly unreasonable". [12] [13] The code provides three possible ways for companies to achieve a safe-harbor valuation of their common stock: [14]

The code defines "illiquid stock of a startup corporation" as stock of a corporation that meets the following criteria: [15]

Industry commentators pushed for specific guidelines regarding the definition of a "qualified individual" who could perform the valuation for an illiquid startup. The final regulations did not provide specific examples of the qualifications necessary to perform a 409A valuation for an illiquid startup, highlighting that the requisite experience "could be obtained in many ways". [15] [12] However, the final regulations clarified that:

Given the small budgets of illiquid startups, many industry participants (including companies and their investors) became frustrated by the need to pay for potentially costly valuations by independent valuation firms. [16] Some valuations could initially cost $50,000, a sum that most startups could never pay. [16] However, recent 409A valuation prices for startup companies have decreased to $1,500–5,000 range, depending on the stage of the company receiving the valuation. [17] For pre-IPO companies and very late-stage companies the prices can be significantly higher as the need for more frequent valuations increases.

Criticisms of IRC 409A

Industry commentators have had ongoing concerns with Section 409A. From its announcement and finalization, the IRS itself has recognized that many industry commentators have expressed concerns about the complexity and reasonableness of several aspects of the law. [8] [ failed verification ] Particular criticisms have included: [18]

See also

Related Research Articles

In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodic employee contributions come directly out of their paychecks, and may be matched by the employer. This legal option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers.

<span class="mw-page-title-main">Employee stock option</span> Complex call option on the common stock of a company, granted by the company to an employee

Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.

In the United States, a 403(b) plan is a U.S. tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001. Both plans also require that distributions start at age 72 (according to the rules updated in 2020), known as Required Minimum Distributions (RMDs). Distributions are typically taxed as ordinary income.

The 457 plan is a type of nonqualified, tax advantaged deferred-compensation retirement plan that is available for governmental and certain nongovernmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pretax or after-tax (Roth) basis. For the most part, the plan operates similarly to a 401(k) or 403(b) plan with which most people in the US are familiar. The key difference is that unlike with a 401(k) plan, it has no 10% penalty for withdrawal before the age of 55. These 457 plans can also allow independent contractors to participate in the plan, where 401(k) and 403(b) plans cannot.

<span class="mw-page-title-main">Retirement plans in the United States</span>

A retirement plan is a financial arrangement designed to replace employment income upon retirement. These plans may be set up by employers, insurance companies, trade unions, the government, or other institutions. Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Federal tax aspects of retirement plans in the United States are based on provisions of the Internal Revenue Code and the plans are regulated by the Department of Labor under the provisions of the Employee Retirement Income Security Act (ERISA).

The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code (USC). It is organized topically, into subtitles and sections, covering income tax in the United States, payroll taxes, estate taxes, gift taxes, and excise taxes; as well as procedure and administration. The Code's implementing federal agency is the Internal Revenue Service.

Incentive stock options (ISOs), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. ISOs are also sometimes referred to as statutory stock options by the IRS. ISOs have a strike price, which is the price a holder must pay to purchase one share of the stock. ISOs may be issued both by public companies and private companies, with ISOs being common as a form of executive compensation for public companies, and common as a form of equity compensation in private start-up companies.

Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a later date after which the income was earned. Examples of deferred compensation include pensions, retirement plans, and employee stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee receives the income.

Restricted stock, also known as restricted securities, is stock of a company that is not fully transferable until certain conditions (restrictions) have been met. Upon satisfaction of those conditions, the stock is no longer restricted, and becomes transferable to the person holding the award. Restricted stock is often used as a form of employee compensation, in which case it typically becomes transferable ("vests") upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share goals or other financial targets. Restricted stock is a popular alternative to stock options, particularly for executives, due to favorable accounting rules and income tax treatment.

<span class="mw-page-title-main">Pensions in the United States</span> Overview of pensions in the United States of America

Pensions in the United States consist of the Social Security system, public employees retirement systems, as well as various private pension plans offered by employers, insurance companies, and unions.

Non-qualified stock options are stock options which do not qualify for the special treatment accorded to incentive stock options.

In the United States, a Rabbi trust is a type of trust used by businesses or other entities to defer the taxability to the person or entity receiving such payments as employee compensation or purchase payments in the acquisition of another business.

The United States Internal Revenue Service uses forms for taxpayers and tax-exempt organizations to report financial information, such as to report income, calculate taxes to be paid to the federal government, and disclose other information as required by the Internal Revenue Code (IRC). There are over 800 various forms and schedules. Other tax forms in the United States are filed with state and local governments.

Phantom stock is a contractual agreement between a corporation and recipients of phantom shares that bestow upon the grantee the right to a cash payment at a designated time or in association with a designated event in the future, which payment is to be in an amount tied to the market value of an equivalent number of shares of the corporation's stock. Thus, the amount of the payout will increase as the stock price rises, and decrease if the stock falls, but without the recipient (grantee) actually receiving any stock. Like other forms of stock-based compensation plans, phantom stock broadly serves to align the interests of recipients and shareholders, incentivize contribution to share value, and encourage the retention or continued participation of contributors. Recipients (grantees) are typically employees, but may also be directors, third-party vendors, or others. Business owners may offer phantom stocks as a way to reward and retain employees, however employees can only own phantom stock during the duration of their employment with the company.

In economics, a gift tax is the tax on money or property that one living person or corporate entity gives to another. A gift tax is a type of transfer tax that is imposed when someone gives something of value to someone else. The transfer must be gratuitous or the receiving party must pay a lesser amount than the item's full value to be considered a gift. Items received upon the death of another are considered separately under the inheritance tax. Many gifts are not subject to taxation because of exemptions given in tax laws. The gift tax amount varies by jurisdiction, and international comparison of rates is complex and fluid.

In the United States, the question whether any compensation plan is qualified or non-qualified is primarily a question of taxation under the Internal Revenue Code (IRC). Any business prefers to deduct its expenses from its income, which will reduce the income subject to taxation. Expenses which are deductible ("qualified") have satisfied tests required by the IRC. Expenses which do not satisfy those tests ("non-qualified") are not deductible; even though the business has incurred the expense, the amount of that expenditure remains as part of taxable income. In most situations, any business will attempt to satisfy the requirements so that its expenditures are deductible business expenses.

Section 79 of the U.S. Internal Revenue Code sets out the U.S. Federal income tax law concerning term life insurance plans provided by employers. Tax benefits are available for both employers and participating employees, under certain conditions.

An Employee Stock Ownership Plan (ESOP) in the United States is a defined contribution plan, a form of retirement plan as defined by 4975(e)(7)of IRS codes, which became a qualified retirement plan in 1974. It is one of the methods of employee participation in corporate ownership.

<span class="mw-page-title-main">Employee compensation in the United States</span>

Employer compensation in the United States refers to the cash compensation and benefits that an employee receives in exchange for the service they perform for their employer. Approximately 93% of the working population in the United States are employees earning a salary or wage.

A Solo 401(k) (also known as a Self Employed 401(k) or Individual 401(k)) is a 401(k) qualified retirement plan for Americans that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s). The general 401(k) plan gives employees an incentive to save for retirement by allowing them to designate funds as 401(k) funds and thus not have to pay taxes on them until the employee reaches retirement age. In this plan, both the employee and his/her employer may make contributions to the plan. The Solo 401(k) is unique because it only covers the business owner(s) and their spouse(s), thus, not subjecting the 401(k) plan to the complex ERISA (Employee Retirement Income Security Act of 1974) rules, which sets minimum standards for employer pension plans with non-owner employees. Self-employed workers who qualify for the Solo 401(k) can receive the same tax benefits as in a general 401(k) plan, but without the employer being subject to the complexities of ERISA.

References

  1. ↑ Stumpff, Andrew (November 2007). "Deferred Compensation and the Policy Limitations of the Nuclear Option". SSRN   1660709.
  2. ↑ "Internal Revenue Bulletin: 2005-2". Internal Revenue Service. January 10, 2005.
  3. ↑ "The Ticktock of the Section 409A Clock – SGR Law". www.sgrlaw.com. Retrieved 2018-05-29.
  4. ↑ "Timing Your Deferred Compensation Distributions - Fidelity Investments". www.fidelity.com. Retrieved 2018-05-29.
  5. ↑ "409A Valuation Guide - Everything you need to know about IRS 409 A Valuations - Redwood Valuation Partners". Redwood Valuation Partners. Retrieved 2018-05-29.
  6. ↑ "26 CFR 1.409A-2 - Deferral elections". LII / Legal Information Institute. Retrieved 2018-05-29.
  7. ↑ "Why do I Need to Get an IRC Section 409A Valuation?". 2012-08-02.
  8. 1 2 "American Jobs Creation Act of 2004". 22 October 2004. Retrieved 15 March 2016.
  9. ↑ "Data Show Widespread Employee Ownership in U.S." Retrieved 21 March 2016.
  10. ↑ "Internal Revenue Bulletin: 2007-19, Section "Explanation..." III D 2". 7 May 2007. Retrieved 2017-03-18.
  11. ↑ "The Impact of Section 409A on Option Grants" (PDF). April 2009. Retrieved 21 March 2016.
  12. 1 2 "Internal Revenue Bulletin: 2007-19, Section "Explanation..." III D 4 c ii". 7 May 2007. Retrieved 2017-03-18.
  13. ↑ "Internal Revenue Bulletin: 2007-19, Section 1.409A-1 b 5 iv B 2". 7 May 2007. Retrieved 2017-03-18.
  14. ↑ "409A Valuation Safe Harbor Guide | Five23" . Retrieved 2019-08-25.
  15. 1 2 "Internal Revenue Bulletin: 2007-19, Section 1.409A-1 b 5 iv B 2 iii". 7 May 2007. Retrieved 2017-03-18.
  16. 1 2 "409A – The Valuation Process". 18 December 2005. Retrieved 21 March 2016.
  17. ↑ "409A Valuations: The Data Driven Guide to a Quick and Painless Report" . Retrieved 21 March 2016.
  18. ↑ "Valuation Shell Game: Silicon Valley's Dirty Secret". The New York Times. 2017-03-08. ISSN   0362-4331 . Retrieved 2018-05-29.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.