Exceptions to 409A: What you need to know

Exceptions to 409A for Compensation Plans and Arrangements

409A is a section of the Internal Revenue Code that governs the tax treatment of nonqualified deferred compensation plans. It was enacted to prevent executives and highly compensated employees from deferring income in order to receive favorable tax treatment.

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However, there are certain exceptions to the rules of 409A that allow for certain types of compensation to be exempt from the regulations. These exceptions exist to accommodate specific circumstances and ensure that employees and employers are able to structure compensation arrangements in a way that makes sense for their unique situations.

One of the most important exceptions to 409A is for short-term deferrals. According to the IRS, compensation that is paid within 2 and a half months after the end of the employer’s tax year in which the right to the compensation is no longer subject to a substantial risk of forfeiture is not subject to 409A. This exception allows employers to provide bonuses and other short-term compensation without triggering the 409A rules.

Another exception to 409A is the exception for stock options. Under this exception, stock options that are granted with an exercise price equal to or greater than the fair market value of the stock on the date of grant are not subject to 409A. This exception recognizes that the value of stock options can fluctuate and allows employers to grant options at a fair and reasonable price without running afoul of the 409A rules.

In addition to these exceptions, there are other exceptions for certain types of severance pay, reimbursements, and other types of benefits. These exceptions are designed to provide flexibility for employers while still ensuring that the spirit of 409A is upheld. It is important for employers and employees alike to be familiar with these exceptions in order to navigate the complex rules surrounding nonqualified deferred compensation plans.

Understanding Exceptions to 409A

When it comes to Section 409A of the Internal Revenue Code, there are several exceptions that individuals and organizations should be aware of. These exceptions provide flexibility and allow for certain arrangements to be exempt from the nonqualified deferred compensation rules.

One exception to 409A is the short-term deferral rule. This exception applies to compensation that is paid within the first two and a half months of the following year. If the compensation meets the criteria of the short-term deferral rule, it is not subject to 409A’s requirements.

Another exception is the separation pay exception. This applies to compensation that is paid to an employee as a result of separation from service. In order to qualify for this exception, certain requirements must be met, such as the separation pay being less than two times the employee’s annualized compensation for the preceding year.

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The next exception is the stock rights exception. This exception applies to certain stock options and stock appreciation rights (SARs). It allows for these arrangements to be exempt from 409A as long as they meet certain requirements, such as being granted with an exercise price that is at least equal to the fair market value of the underlying stock at the time of grant.

Additionally, there is an exception for certain reimbursements and in-kind benefits. This exception applies to reimbursements for medical expenses, as well as certain in-kind benefits, such as limited executive physical examinations. These reimbursements and benefits are generally excluded from 409A’s requirements.

It is important to note that each exception has specific criteria and requirements that must be met in order to qualify. It is advisable to consult with a tax professional or attorney to ensure compliance with 409A and its exceptions.

In summary, understanding the exceptions to 409A is crucial for individuals and organizations to navigate the rules and regulations surrounding nonqualified deferred compensation. These exceptions provide flexibility and allow for certain arrangements to be exempt from 409A’s requirements. However, it is important to ensure that the specific criteria and requirements of each exception are met in order to qualify.

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Key Exemptions for Nonqualified Deferred Compensation

Nonqualified deferred compensation plans are subject to the rules and regulations outlined in Section 409A of the Internal Revenue Code. However, there are some key exemptions that allow certain types of compensation to be excluded from the provisions of 409A.

Here are some of the key exemptions for nonqualified deferred compensation:

Short-Term Deferrals: Under Section 409A, certain short-term deferrals are exempt from the rules. A short-term deferral is a payment made within the 2½ months following the end of the year in which the compensation is no longer subject to a substantial risk of forfeiture. This exemption is commonly used for annual bonuses and other short-term incentive plans.
Severance Pay: Severance pay that meets specific requirements is exempt from the provisions of 409A. To qualify for the exemption, severance pay must be paid within 2 years following the employee’s separation from service and cannot exceed twice the employee’s annualized compensation.
Qualified Retirement Plans: Nonqualified deferred compensation that is provided through a qualified retirement plan, such as a 401(k) or pension plan, is generally exempt from the 409A rules. However, there are specific requirements that must be met for the exemption to apply.
Restricted Stock Units (RSUs): RSUs are often exempt from 409A if certain conditions are met. The RSUs must be granted by an eligible issuer and the amount payable upon settlement must be based solely on the value of the employer’s stock.
Stock Options and Stock Appreciation Rights (SARs): Stock options and SARs that are granted with an exercise price equal to or greater than the fair market value of the underlying stock on the grant date are exempt from 409A. However, if the exercise price is below fair market value, the options or SARs are subject to the rules of 409A.

It’s important for employers and employees to understand these key exemptions to ensure compliance with the rules and regulations surrounding nonqualified deferred compensation. Failing to meet the requirements of 409A can result in significant tax penalties for both the employer and employee.

FAQ:

What is Section 409A?

Section 409A is a part of the Internal Revenue Code (IRC) in the United States that regulates nonqualified deferred compensation plans. It aims to ensure that highly compensated employees do not use these plans to defer income and thereby avoid current income tax.

What are the main exceptions to Section 409A?

There are several exceptions to Section 409A. Some of the main exceptions include: separation pay plans, short-term deferral exceptions, and certain stock options and stock appreciation rights. These exceptions provide flexibility for employers and employees in structuring their compensation plans.

How does the separation pay exception work?

The separation pay exception allows employers to make certain payments to employees upon a separation from service without triggering Section 409A. To qualify for this exception, the payment must meet certain requirements, such as being made within a specified period of time after separation and not exceeding a certain amount.

What are the consequences of noncompliance with Section 409A?

Noncompliance with Section 409A can result in severe tax consequences for both employers and employees. If a plan is found to violate Section 409A, the compensation deferred under the plan may become immediately taxable, subject to additional tax penalties and interest. It is crucial for employers and employees to understand and comply with the rules of Section 409A to avoid these penalties.