IRC Section 409A applies to officers with "non-qualified deferred compensation plans"--which roughly means it applies to any present legally enforceable right of a service provider (like an officer) to receive payment in a later year of any taxable compensation for services. It is broad, so Section 409A can apply to non-qualified retirement plans, elective deferrals of compensation, severance and separation programs, post-employment benefit payments provided for in an employment termination agreement, stock options, other equity incentive programs, reimbursement arrangements and a variety of other possible items.
All of the tax penalties for Section 409A violations are imposed on the service provider (the officer, key employee or other worker).
No penalties are imposed on the company or other organization making the payments. Thus, while an employer who adopts a deferred compensation plan may seek legal advice concerning its Section 409A compliance, getting things wrong will have major consequences not for the employer but for the officers--who may have had no role in drafting the plan.
What is a Section 409A violation? Section 409A can be violated in one of two general ways. First, it will be violated simply because documentation is not written correctly, which means if a nonqualified deferred compensation plan includes provisions that are inconsistent with the Section 409A rules. Second, Section 409A penalties can be applied if an action is taken concerning the payment of deferred compensation that violates the Section 409A rules, even if such action is inconsistent with the terms of the relevant written plans. Thus, Section 409A requires both “documentary” and “operational” compliance.
The consequences of a Section 409A documentary or operational failure, in either case, are substantial tax penalties for the affected service providers (employees or other workers). First, the nonqualified deferred compensation in question will be fully taxable as soon as the service provider has a vested (nonforfeitable) right to receive it. Second, a 20% additional tax penalty on the value of the nonqualified deferred compensation will be imposed at the same time. In addition, under certain circumstances, an interest charge will be imposed. Generally speaking, in the case of a documentary failure the penalties would be applied to all participants who are affected by the provision in question. If an operational failure occurs, only the service provider to whom the operational failure relates will be penalized. Once an operational violation occurs, however, penalties are imposed not only with respect to the item of deferred compensation that violated the rules, but also on all similar nonqualified deferred compensation rights. “Similar” means rights under deferred compensation plans of a like type. Plans are divided into eight types: elective account balance plans, nonelective account balance plans, nonaccount balance (such as defined benefit) plans, separation pay plans, split-dollar insurance plans, in-kind benefit and reimbursement plans, stock rights and foreign plans. Thus, for example, if an operational violation occurs with respect to a service provider’s rights under a particular nonelective account balance plan, the penalties will be imposed on all nonelective account balance rights that the participant has with the same service recipient (employer), even if the other plans do not violate Section 409A. As a result of this sweeping aggregation rule, a Section 409A operational violation that seems to affect only a small amount could produce enormous penalties for the officer.