What Is 409A Deferred Compensation And Should I Offer It?

If you’re thinking about offering a deferred compensation plan to your employees, you need to understand the implications first. While it’s a popular technique for attracting and retaining industry talent, it comes with some strict rules. The IRS lays them out in Section 409A, which governs how and when deferred pay can be earned and distributed. Understanding this in-depth will protect you, keep your employees happy, and help prevent you from making expensive mistakes.

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What Is Deferred Compensation?

In basic terms, deferred compensation does what it says on the tin. It’s when your employees earn money now, but they defer their compensation, meaning they receive it later. The specific compensation could be a monetary bonus, stock options, or other financial incentives. They may not get paid out until years down the line.

To learn more about 409a deferred compensation, let’s consider why it might be beneficial. You might use deferred compensation to reward long service or offer an incentive to stay in the company.

It also enables you to provide an attractive benefit without an immediate impact on your cash flow, or in the employees’ eyes, an immediate impact on their tax bill. For example, you might promise a senior manager a $50,000 bonus payable after five years with the company. Ultimately, it’s a powerful retention tool.

What Is Section 409A?

Section 409A of the Internal Revenue Code lays out how and when employees can make elections to defer income, when those payouts can be made, and what events trigger them. If you don’t follow 409A rules, the URS can hit your employees with immediate income taxes, a 20% penalty, and interest charges. That’s not a good look for you, as their employer.

Things To Know Before Offering It

Before you launch a deferred compensation plan, you need to understand and follow the key 409A requirements:

Election timing: Employees must elect to defer income before the year it’s earned.
Permitted payout events: Must be a specific event like a set date, end of service, change in company ownership, disability, or death.
No schedule changes: Once the payout trigger is set, it generally cannot be changed without penalties.
Written documentation: A formal written plan must be maintained every term.
Funding considerations: Usually, you pay 409A plans from company assets at the time of payout, but you could use a compliant trust.
Coordination with other benefits: Stock options, restricted stock units (RSUs), and bonuses may trigger early taxation if not timed correctly.

In terms of avoiding common mistakes, don’t put off getting legal or tax advice: involve an attorney at every stage. Don’t make it too broad and complex; you can offer the plan to select employees only. Finally, ensure consistent, transparent, and frequent communication with the relevant employees to avoid misunderstandings.

Endnote

Before you offer deferred compensation, get to grips with the 409A regulations. Learn them like a rulebook, follow them, and document everything. When managed correctly, deferred compensation can help you keep your top talent in-house and reward employee loyalty. It also means you can offer a competitive edge in your industry. Most importantly, do it by the book to avoid putting your company at risk.