Are Your Nonqualified Deferred Compensation Plans in Compliance with 409A?
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There are various exceptions, excluding from 409A rules compensation that would otherwise fall in this definition, including: qualified plans like pension and 401k plans, welfare benefits including vacation leave, sick leave, disability pay, and death benefit plans.2 Other exceptions include those for “short-term deferrals” or payments made within 2-½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture,3 certain stock option and stock appreciation rights, i.e. restricted stock plans and certain separation pay plans.
Nonqualified deferred compensation plans subject to 409A must comply with various rules regarding the timing of deferrals and distributions. The timing requirements for distributions are met if the plan provides that compensation deferred under the plan may not be distributed earlier than the following, if applicable: (a) the date a participant becomes disabled; (b) separation from service or retirement; (c) death; (d) a specified time identified under the plan at the date of the deferral of such compensation; (e) a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation; (f) the occurrence of an unforeseeable emergency (i.e. severe financial hardship from an illness or accident).4 The plan must also provide that payments of benefits may not be accelerated.5
Generally, elections must be made in the participant’s first year of eligibility. Specifically for regular compensation, the election must be made within 30 days of the date the employee becomes eligible to participate in the plan. In the case of performance-based compensation, based on services performed over a period of at least 12 months, an election should be made no later than 6 months before the end of the period.6
Common types of arrangements that may be subject to 409A include: traditional deferred compensation plans; discounted stock options and discounted SARs; performance share awards, phantom stock, and other equity awards; annual and multi-year bonus and commission plans; offer letters and employment agreements, change in control and severance agreements and/or plans; and reimbursement arrangements covering multiple years.
If a deferred compensation plan violates the provisions of 409A, then compensation is subject to: (a) taxation at the time the compensation becomes vested, regardless of whether or when it is ultimately paid; (b) an additional 20% of federal income tax; (c) additional interest and penalties; (d) in certain cases, additional state taxes may apply. Additionally, the employer would have to withhold income taxes and employment taxes on this income.7
Start-up Companies & Stock Options:
A nonstatutory stock option is not considered to be deferred compensation for purposes of 409A if three conditions are met: (a) exercise price is equal to or greater than FMV determined as of the option grant date; (b) the option is subject to taxation under §83; (c) the option does not include any deferred compensation feature other than deferred income recognition until exercise or disposition of the option. On the other hand, generally, if a stock option has an exercise price that is less than the fair market value (FMV) of the underlying stock, determined as of the option grant date, it is considered a deferred compensation arrangement under 409A.8 Therefore, it’s important for companies granting stock options to make sure that the exercise price of the shares issued is equal to or greater than the FMV at the grant date, established by a reasonable valuation method.
For stock that trades on an established market, it’s permissible to use the following methods for deriving FMV: the last sale price before grant, first sale price after grant, closing price on the trading day before or after grant, etc.9 Conversely, under 409A, determining the FMV of a start-up company’s stock that is not traded on an established market is not as clear and requires the application of one of three reasonable valuation safe harbor methods. The method most relevant for valuing the stock of start-up companies, defined as those that have been in business for less than 10 years, have no publicly traded class of securities, and do not reasonably anticipate a change in control within 90 days or a public offering within the next 180 days, is a reasonable, good-faith valuation evidenced by a written report issued by someone who is qualified, but not necessarily independent. All facts and circumstances of the company must also be considered, i.e. value of assets, present value of future cash flows, etc.10 The appraiser must have at least five years of relevant experience in business valuation.
Before granting options to employees, it’s important to consider the provisions of 409A. Companies should consult with their tax advisors to determine a reasonable valuation method to establish the FMV of underlying shares issued and to make sure their nonqualified deferred compensation plans are in compliance with 409A.
2. IRC §1.409A-1(a)(2), IRC §1.409A-1(a)(5)
3. IRC §1.409A-1(b)(4)
4. IRC §1.409A(a)(2)
5. IRC §1.409A(a)(3)
7. IRC §1.409A(a)(1)(A), IRC §1.409A(a)(1)(B)
8. Reg. § 1.409A-1(b)(5)(i)(A)
9. IRC §1.409A-1(b)(5)(iv)(A)
10. IRC §1.409A-1(b)(5)(iv)(B)(2)
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Christine Mellusi, CPA T (973) 898 9494 [email protected]
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