Do you have accrued wages or bonuses? Beware of IRC Section 409A
Did you defer wages or bonuses for employees or contractors until after year-end? If so, watch out for Internal Revenue Code (IRC) Section 409A. Service providers could see a 20% penalty tax if they have nonqualified deferred compensation that fails to meet the requirements of Section 409A.
Deferral of compensation
Section 409A applies to compensation that workers earn in one year but is not paid until a future year, according to the terms of a compensation plan. It’s called “nonqualified deferred compensation.”
For example, say a company awarded a bonus to an employee on December 31, 2015, that was expected to be paid on May 1, 2016. Assuming the employee has a legally binding right to the payment on December 31, 2015, this bonus would be considered “deferred compensation” under Section 409A rules.
Nonqualified deferred compensation plans are subject to the rules in Section 409A unless an exception applies. The 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 rules are violated.
Surprisingly to most employees, tax penalties are imposed on the employee and not the employer. Employers have reporting and withholding obligations they are required to meet.
Short-term deferral exception under Section 409A
In general, a deferral of compensation does not occur if the payment is required and 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).
Example 1: On November 30, 2015, an employer awards a bonus to an employee. On that date, the employee has a legally binding right to the bonus. The company 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 (2.5 months after the employee’s year-end), it meets the short-term deferral exception and will not be subject to the requirements under Section 409A.
Example 2: Assume all facts are the same, except the employer has a taxable year ending August 31, 2016. The bonus will meet the short-term deferral exception if it’s paid on or before November 15, 2016 (2.5 months after the employer’s tax year).
Compensation that is designated to be paid within the applicable two-and-a-half-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 period or
- The employer is in financial hardship and would go bankrupt by 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 Section 409A
Section 409A imposes four general categories of requirements that nonqualified deferred compensation plans must satisfy to avoid penalties and interest. They are:
Distribution restrictions: Deferred compensation cannot be distributed earlier than one of six specified events:
- Separation from service
- Disability
- Death
- 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 Section 409A on Forms 1099 or W-2.
- Employees: 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% penalty under Section 409A; therefore, the employee should be aware that estimated tax payments may be required to cover the penalty.
- Non-employees: 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 Section 409A.
How Wipfli can help
Could your deferred compensation plan fall under Section 409A guidelines? Let’s find out. Wipfli’s tax professionals can help evaluate your compensation plans, including stock options and equity awards. Contact us today to get started.
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