Sec. 409A: where do taxpayers stand?

• Author: Hill, Kevin C.

One of the more burdensome aspects of the American Jobs Creation Act of 2004 (AJCA) is Sec. 409A, which deals with taxation of nonqualified deferred compensation (NQDC) and is rather restrictive in its timing of taxation of such plans. Simply put, it requires including any NQDC in a recipient's income, unless it is subject to a substantial risk of forfeiture. The law was imposed due to recent abuses by top employees of various companies. Accordingly, the AJCA House Report (H Rep't No. 108-548 (Part 1), 108th Cong., 2d Sess. (2004)) noted:

The Committee is aware of the popular use of deferred compensation arrangements by executives to defer current taxation of substantial amounts of income. The Committee believes that many nonqualified deferred compensation arrangements have developed which allow improper deferral of income. Executives often use arrangements that allow deferral of income, but also provide security of future payment and control over amounts deferred. For example, nonqualified deferred compensation arrangements often contain provisions that allow participants to receive distributions upon request, subject to forfeiture of a minimal amount (i.e., a "haircut" provision).

Purpose

Before Sec. 409A, the available NQDC guidance was rather lenient, with a lot of potential for creativity, often leaving taxpayers to rely on case law and IRS rulings. Sec. 409A was designed to eliminate the uncertainty, as well as to restrict potential abuses. Its rules do not overrule other Code provisions, however. For example, if Sec. 83 applies, it might preempt Sec. 409A. Indeed, Sec. 409A's provisions will often interact not only with Sec. 83, but also with Sec. 451 and the constructive receipt rules, as well as other Code provisions.

Failure to Comply

Sec. 409A imposes severe penalties for noncompliance. If an NQDC plan fails to qualify under its deferral provisions, all previously deferred amounts that are no longer subject to a substantial risk of forfeiture have to be included in the taxpayer's income in the year the failure to comply occurs; see Sec. 409A(a)(1)(A).

Further, failure to comply triggers a penalty of 20% of the compensation deferred. Interest at the underpayment rate, plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the tax year in which first deferred (or, if later, the first tax year in which such deferred compensation is not subject to a...