Executive Compensation - Code Section 409A
Section 409A of the Internal Revenue Code (the "Code") was created in 2004, assessing an excise tax on "deferrals of compensation" that do not comply with certain requirements. Generally speaking, a "deferral of compensation" is compensation paid in one tax year for services rendered in another tax year. The applicability of Section 409A is quite broad, covering many arrangements between employers and employees (or independent contractors), including employment/consulting agreements, severance packages, retention bonuses, partnership agreements, executive medical benefits and the like.
Compensation that is within the definition of "deferral of compensation" under Code Section 409A must comply with certain rules, principally that the time and manner of ultimate payment be established in writing prior to the performance of services for which the compensation is earned. Prior planning and detailed documentation can ensure compliance or, even better, that the arrangement will fit within one of the numerous exceptions under Code Section 409A. For example, compensation subject to a legitimate, documented "substantial risk of forfeiture" (e.g., the provision of additional services) can be exempted from Code Section 409A. Code Section 409A also contains exemptions for severance, stock rights, COBRA reimbursement, retention bonuses and performance bonuses assuming the satisfaction of certain requirements.
The penalty for failure to comply with Code Section 409A is a 20% excise tax plus interest and penalties for the failure to declare and pay taxes in the proper year. For example, a $50,000 deferral of compensation from 2010 until 2013 that does not comply with Code Section 409A creates a liability of $10,000 in excise tax plus interest and penalties for not declaring and paying taxes on the compensation for the period from 2010 through 2013. The penalty for failure to comply with Code Section 409A is assessed against the employee or independent contractor.