• Paul Peter Nicolai

409A Compliance Traps

Two sections of the Internal Revenue Code continue to challenge companies in creating compensation arrangements. They are Section 409A (“409A”) that governs the treatment of nonqualified deferred compensation arrangements, and Section 162(m), which limits the annual compensation deduction a public company may take for certain executive officers. This memo notes some of the key pitfalls that can cause unintended consequences and penalties under 409A. Since Section 162(m) only applies to public companies, we will leave it for another day.


409A is a full set of requirements that govern the broadly defined universe of nonqualified deferred compensation arrangements. Violations, both on paper and in operation, can mean significant money penalties for both employers and executives who are parties to these arrangements.

The 2014 announcement by the IRS that it began auditing 409A arrangements has upped the pressure to make sure all arrangements are in compliance. This makes it more critical that companies emphasize developing procedures for identifying potential 409A risks and ensuring compliance.

Here are some of the main 409A compliance issues.


One reason for many unplanned violations of 409A is not identifying that the particular deal is subject to it. This happens because 409A applies to a wide variety of deals not thought of as allowing for deferred compensation. 409A covers not only traditional deferred compensation deals involving deferring salary and bonus, but also many employment, change in control, and severance deals, phantom stock awards, deferred shares and restricted stock units, and bonus payments.

409A is not limited to public companies or high-ranking or highly paid executives. It applies to both private and public companies and to nearly all service providers, including executives and other employees, nonemployee directors, and most independent contractors. Because of this, nearly every compensation deal must be looked at to determine if it is subject to 409A.

409A also is not limited just to individuals providing services in the U.S., but extends to some foreign deferred compensation arrangements. It applies to all income payable to U.S. taxpayers, regardless of the country the compensation is earned in unless an exemption applies. U.S. taxpayers include U.S. citizens, green card holders, and temporary residents. For nonresident aliens, deferred compensation is generally subject to 409A only if the services were performed in the U.S.


The initial election to defer payment of nonqualified deferred compensation must comply with a detailed set of 409A rules. In general, an initial election to defer compensation must:

  1. be in writing,

  2. be irrevocable,

  3. specify a payment date or event that is permissible under 409A, and

  4. be made before the beginning of the year in which the compensation is earned.

This final rule on the timing of the election creates issues because it is counterintuitive. Assume an employee would like to defer a portion of his or her 2016 base salary and a portion of the annual bonus that will be paid to him or her in early 2016 based on that person’s 2015 performance. The base salary deferral must be made by December 31, 2015 because it is for compensation that will be earned in 2016. The annual bonus deferral generally must be made by December 31, 2014, because while the bonus payment will not be made until 2016, the bonus itself was earned in 2015. This is the case even if the bonus is purely discretionary.

Limited exceptions to these general rules are sometimes available, but they are complex and can be difficult to apply. A careful review is necessary before applying them to a specific situation.


409A contains exemptions for some equity awards but not for others. Care must be taken to ensure equity awards are structured in a way that is either compliant with or exempt from 409A.

409A generally does not apply to restricted stock, partnership interests, or stock options or stock appreciation rights (SARs) granted with an exercise price that is at least equal to the fair market value of the underlying stock on the grant date. If stock options or SARs have an exercise price that is less than the fair market value of the underlying stock on the grant date, then 409A will apply, and the award must be structured in a way that complies with the applicable 409A rules (for example, by limiting the exercise period to a single year).

Restricted stock units (RSUs) are a type of equity award that is not specifically exempt from 409A. While an RSU that is paid out only on vesting is exempt from 409A under its short-term deferral exception, some common design elements may result in an RSU which is subject to 409A. These include accelerated vesting on retirement or on termination of employment for good reason, where good reason is defined in a way that does not meet the 409A standard for treatment as an involuntary termination, or continued vesting following retirement or other termination of employment, including during a post-termination noncompetition period.

RSUs subject to 409A have far less flexibility than RSUs that are exempt under the short-term deferral exception. For example, RSUs that are subject to 409A:

1. must be paid only on permissible payment events,

2. must define terms in a way that complies with 409A, and

3. generally, cannot have payment accelerated, although vesting may be accelerated.

To identify RSUs structured in a way that subjects them to 409A, companies should review all agreements and arrangements that may contain provisions applicable to RSU awards. Often, termination terms applicable to RSU awards and other equity awards, are in employment agreements or change in control agreements. It is critical to review all arrangements that may impact RSU terms.


Separation from service is a permissible payment event under 409A, but not all events generally considered to result in the separation of an individual’s service from an employer will qualify under the rules. Care must be taken to ensure a qualifying separation from service has happened before paying nonqualified deferred compensation to a service provider due to separation.

For employees, a separation from service generally happens on the date the employer and employee reasonably expect that the employee’s level of services will be reduced by at least 80 percent from the employee's average service level for the trailing three-year period. Although this clearly includes a complete end of services, it is also mandatory that a continuing service level of 20 percent or less be treated as a separation. Since the test is based on service level and not employment status, treatment as an employee or independent contractor going forward does not affect it. Determinations of expected future services must be based on the reasonable expectations of the parties, which may or may not be accurate. If the reasonable expectations of the parties end up not being accurate, there are presumptions to evaluate actual service levels, including that a service level in excess of 50% of the trailing three-year average will presumptively indicate a separation from service did not happen, and an 80% or more reduction will presumptively indicate a separation has happened.

For an independent contractor (including nonemployee board members), a separation from service happens when there is a complete termination of a contractual relationship. A continuing contract relationship, even under a different status will delay separation from service until the good faith, complete termination of all contracts for services with the contractor. However, if an individual who serves as both an employee a member of the company’s board of directors ends employment, the individual’s continuing director service will generally be disregarded for determining whether the individual has incurred a separation from service.

The separation from service rules can be complex. It is critical to use caution to make sure a separation from service has happened before making the payment of nonqualified deferred compensation to a service provider due to separation.


Many severance arrangements require a terminating service provider to execute a release of claims before the severance payment will be made. The period of time the service provider is given to consider the release before signing it may make an otherwise exempt arrangement subject to 409A.

The IRS has said in 409A corrections guidance that it views a plan provision that provides for payment following execution of a release to be a problem if the requirement effectively allows a service provider to influence the year of payment through the timing of delivery of a release. Even where the employer has not committed to a particular time frame for payment, other than to specify a 409A compliant payment period and to make payment subject to delivery and non-revocation of a release, the IRS has indicated these provisions may trigger a documentary violation under 409A unless the plan terms preclude the service provider from influencing the year of payment.

Two ways to address this are to provide that either payment will always be made on a fixed date following the date of termination, subject to the earlier delivery and non-revocation period, or, where the specified period for delivery and non-revocation of a release spans two taxable years, payment will always be made in the second taxable year but within 409A's timing requirements.

Recent Posts

See All


On December 21, Congress passed, and the President later signed, a spending bill that folded in several intellectual property provisions that expand the rights of intellectual property owners. These p

Remote Work Legal Issues

Technology and changing preferences make remote work possible for a large part of the workforce but before COVID-19 it had not been widely adopted. COVID-19 forced wide-spread acceptance of work-from-