BY G. A. FINCH
If your employment agreement has deferral of compensation provisions, you may very well see a section or paragraph captioned “Internal Revenue Code Section 409A” or simply “409A.” Its official citation is 26 U.S. Code Section 409A – Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.
This section is too complex and tedious for most lay person executives to understand and figure out. Your reading Section 409A of the IRS Code is certainly an instant cure for insomnia.
At the outset, before you execute an employment agreement, your retaining an attorney is necessary to interpret and apply Section 409A to the various scenarios of deferral of compensation to ascertain whether such compensation adheres to Section 409A’s deferrals and distributions timing rules.
Failure to comply with the rules concerning deferred compensation has onerous consequences of 1) inclusion of such deferred compensation as gross income for the subject taxable year, 2) payment of the amount of interest on the underpayments, and 3) a penalty amount equal to 20% of the deferred compensation which is required to be included in gross income.
Accordingly, employers often have a Section 409A provision in the employment agreement that allows the employer to adjust payments under the agreement to comply with Section 409A and allows the employer to disclaim any liability to the employee.
A typical provision can be lengthy paragraphs and include some language like the following:
“Anything in this Agreement to the contrary notwithstanding, the parties intend that all payments and benefits under this Agreement comply with Section 409A of the Code and the regulations promulgated thereunder and, accordingly, to the maximum extent permitted by law, this Agreement shall be interpreted in a manner in compliance therewith. To the extent that any provision hereof is modified in order to comply with Section 409A, such modification shall be made in good faith and shall, to the maximum extend reasonably possible, maintain the original intent and economic benefit to you and the Employer of the applicable provision without violating the provisions of Section 409A. Notwithstanding the foregoing, the Employer shall not be required to assume any increased economic burden in connection therewith. Although the Employer intends to administer this Agreement so that it would be exempt or comply with the requirements of Code Section 409A, the Employer does not represent or warrant that this Agreement will be exempt from, or otherwise comply with, Code Section 409A or any other provision of applicable law. Neither the Employer, its affiliates, nor their respective directors, officers, employees or advisers shall be liable to you (or any other individual claiming a benefit through you) for any tax, interest, or penalties you may owe as a result of compensation paid out pursuant hereto, and the Employer shall have no obligation to indemnify or otherwise protect you from the obligation to pay taxes pursuant to Code Section 409A.”
The point of this blog post is that your deferred compensation provisions could trigger 409A tax consequences and your employer, through its employment contract with you, is shifting the risk to you as employee.