Do you have wages or bonuses that were earned by employees or independent contractors but have not been paid to them after year-end? If you answered yes, you need to be aware of Internal Revenue Code Section 409A. §409A applies to compensation workers earn in one year but is not paid until a future year. It is referred to as non-qualified deferred compensation. Service providers (employees or independent contractors) could see a 20 percent penalty tax if they have non-qualified deferred compensation that fails to meet the requirements of §409A.
Deferral of Compensation
Deferral of compensation occurs when an employee earns wages in a year; however, according to the terms of a compensation plan, the payment will be made to the individual in a later year.
For example, on December 31, 2015, Employer A awards a bonus to Employee B, which is expected to be paid on May 1, 2016. Assuming Employee B has a legally binding right to the payment on December 31, 2015, this bonus will be considered “deferred compensation” under §409A rules.
Non-qualified deferred compensation plans are subject to the rules in §409A unless an exception applies. The §409A rules were designed to prevent an employer from being able to accelerate payments under a deferred compensation plan. The rules impose an additional penalty tax and immediate inclusion in income to the employee/service provider if the §409A rules are violated.
Surprisingly to most employees, tax penalties for §409A violations are imposed on the employee and not on the employer. The employer will have reporting and withholding obligations they are required to meet.
Short-Term Deferral Exception Under §409A
In general, a deferral of compensation does not occur if the payment is required and is actually made to a worker on or before the 15th day of the third month following the end of the worker’s tax year or the employer’s tax year, whichever is later, in which the compensation has been earned (“short-term” deferral).
On November 30, 2015, Employer A awards a bonus to Employee B and on such date, Employee B has a legally binding right to the bonus. Employer A has a taxable year ending November 30, 2015. The bonus plan does not provide for a payment date or a deferred payment. If the bonus is paid on or before March 15, 2016 (2½ months after the employee’s year-end), it meets the short-term deferral exception and will not be subject to the requirements under §409A.
Assume all facts are the same as Example 1 except Employer A has a taxable year ending August 31, 2016. The bonus will meet the short-term deferral exception if paid on or before November 15, 2016 (2½ months after the employer’s tax year).
Compensation designated to be paid within the applicable 2½ month period but is not made until later may continue to qualify as short-term deferral if:
- The taxpayer establishes it was administratively impracticable to make the payment by the end of the applicable 2½ month period, or
- The employer is in financial hardship and would go bankrupt if making such a payment, and the payment is made as soon as administratively practicable or when the employer’s financial position improves.
Requirements Imposed by IRC §409A
§409A imposes four general categories of requirements non-qualified deferred compensation plans must satisfy to avoid penalty and interest imposed under §409A:
- Distribution restrictions: It provides that deferred compensation cannot be distributed earlier than one of six specified events:
- Separation from service
- A specified time (or fixed schedule specified under the arrangement as of the date of deferral), but not an event
- A change in the ownership or effective control of the corporation
- The occurrence of an unforeseeable emergency (e.g., a severe financial hardship to the worker because of an illness or accident, loss of the worker’s property due to casualty, etc.)
- Acceleration restrictions: The plan may not permit the acceleration of the time or schedule of any payment under the plan.
- Election restrictions: In general, the initial election to defer compensation, as well as the time and form of distributions, must be made before the beginning of the tax year in which the services are performed.
- Written plan requirements: The plan must be in writing.
Reporting and Withholding Requirements
An employer must report deferred compensation, which is includible in gross income under §409A on Forms 1099 or W-2.
For an employee, amounts includible in gross income are supplemental wages for income tax withholding purposes. The employer is not required to withhold the 20 percent penalty under §409A; therefore, the employee should be aware that estimated tax payments may be required to cover the 20 percent penalty.
For non-employees, amounts includible in gross income are reported as non-employee compensation on Form 1099-MISC. The independent contractor should be aware that additional estimated tax payments may be required to cover the penalty assessed by §409A.