IRS Section 409A Guide: Complete Compliance Requirements & Safe Harbor Rules

While many company founders may be unaware of IRS Section 409A, it’s an important tax law that governs the rules for valuing a company’s share price. Section 409A, enacted after corporate scandals, sets strict rules for nonqualified deferred compensation like stock options, RSUs, and severance. It requires specific timing for deferral elections and payouts, and violations trigger immediate taxation, a 20% penalty, and interest for participants.

Despite this, not every company may have a valuation done, especially for those without an Employee Share Ownership Plan (ESOP) or compensation to their shareholders. However, if you are about to give shares or options to your employees, then you should know all about IRS Section 409A and the valuation methods. Understanding Section 409A is essential to designing, auditing, or managing deferred compensation plans and avoiding costly tax consequences.

Key Points About Section 409A IRS

Here are the key points about Section 409A of the Internal Revenue Code:

• Regulation of Deferred Compensation: Section 409A sets strict rules for how nonqualified deferred compensation (NQDC) plans must be structured, including when deferrals and payouts can occur and how changes are made.
• Penalties for Noncompliance: Noncompliance can trigger severe employee penalties, such as immediate taxation of all deferred compensation, an extra 20% tax, and interest charges.
• Requirement for Regular Valuations: Companies must obtain regular, independent 409A valuations to determine the fair market value of stock options and ensure compliance.
• IRS Correction Programs: The IRS offers correction programs for unintentional errors, but penalties increase if issues are not addressed quickly
• 409A Valuation Services: Work with an experienced, independent 409A valuation provider to ensure your stock option exercise prices are set at or above fair market value.
• Section 409A Compliance Summary: Align valuation dates, design compliant severance plans, ensure deferred compensation compliance, and secure board approval by the deadline.

What is IRC Section 409A?

Section 409A is an IRS tax rule that requires private companies to properly value their stock before granting employee stock options. If you grant options below fair market value, employees face immediate tax consequences plus 20% penalties.

Who must comply with section 409A?

Section 409A compliance is required for both parties involved in nonqualified deferred compensation arrangements:

• Service Recipients:  These are typically employers or any entities (including companies that hire independent contractors) that offer nonqualified deferred compensation to others.
• Service Providers: This group includes employees, executives, board members, some independent contractors, and even service-providing entities (such as LLCs) who receive deferred compensation.

Both the company (as the service recipient) and the individual or entity receiving deferred compensation (as the service provider) must ensure compliance with Section 409A, but the legal and tax penalties for non-compliance fall primarily on the recipient of the compensation.

When Section 409A applies?

Section 409A applies to any arrangement where a service provider has a legally binding right in one taxable year to compensation that may be paid in a later taxable year. This includes a broad range of nonqualified deferred compensation (NQDC) plans, such as:

• Nonqualified retirement plans
• Elective deferrals of compensation
• Severance and separation pay programs
• Certain post-employment payments
• Stock options and other equity incentive programs (unless specifically exempt)
• Some reimbursement arrangements

The law regulates how and when deferral elections are made, and restricts the timing and form of distributions, generally allowing payment only upon specific events such as separation from service, death, disability, a fixed schedule, change in company control, or unforeseeable emergency.

Key Exemptions from Section 409A

Certain types of compensation and arrangements are exempt from Section 409A, including:

• Qualified employer plans: Such as 401(k), pension, and other tax-qualified retirement plans.
• Short-term deferrals: Amounts paid in full within 2.5 months after the end of the year in which the right to the compensation vests (i.e., no longer subject to a substantial risk of forfeiture).
• Certain welfare benefits: Including vacation leave, sick leave, disability pay, and death benefit plans.
• Certain stock options and stock appreciation rights: If granted at or above fair market value and meeting other specific requirements.
• Section 457 plans and certain foreign plans: As provided by the IRS

Section 409A Deferred Compensation Plans (NQDC)

According to IRC section 409A, the “non-qualified deferred compensation” has to comply with other rules concerning the distributions and timing of deferrals. So, as per the regulations put up by the IRC Section 409A is applied when there is a“deferral of compensation.” This normally takes place when an employee of a company has a legally binding right during a taxable year to the compensation that would be payable in another tax year or is payable in the current tax year.

What is Nonqualified Deferred Compensation (NQDC)?

IRC Section 409A sets out nonqualified deferral election timing and distribution schedules rules. Nonqualified plans must comply with 409A rules to retain their tax-deferred status.

Key exemptions of NQDC

Key exemptions from Section 409A rules that apply to nonqualified deferred compensation are:

• Short-Term Deferrals: Compensation deferred for less than 2.5 months after the end of the tax year in which it was earned is exempt. For example, a bonus earned in 2024 that’s paid by March 15, 2025 would qualify for this exemption.
• Separation Pay Exemptions
  • Two-year rule: Severance payments that don’t exceed two times the employee’s annual compensation and are paid within two years of termination are generally exempt.
  • Window program payments: Voluntary early retirement or separation incentive payments offered for limited periods may qualify for exemption under specific conditions.
• Stock Rights Exemptions: ISOs and ESOP that meet specific tax code requirements are exempt from Section 409A. Stock appreciation rights (SARs) and nonqualified stock options are exempt if the exercise price is never less than FMV when granted and the stock is readily tradeable or meets certain valuation requirements.
• Expense Reimbursements and Benefits: Qualified expense reimbursement arrangements, medical benefits, and certain fringe benefits are typically exempt from Section 409A requirements.

Parts of the IRC Section 409A

Even though we all aren’t lawyers, it’s good for business owners to have at least a basic understanding of the law for their company operations.

Timing of Deferral Elections	This section outlines the rules for when deferral elections must be made, typically requiring that elections be made before the start of the tax year in which the compensation would otherwise be earned
Distribution Timing	Section 409A specifies when deferred compensation may be distributed, including upon separation from service, a fixed date or schedule, disability, death, a change in control, or unforeseeable emergency
Distribution Events and Restrictions	It sets forth the events that trigger the distribution of deferred compensation and any restrictions or penalties for early distributions
Documentary Compliance	Employers must ensure that their NQDC plans comply with the documentary requirements of Section 409A, including the timing of plan adoption and amendment procedures
Operational Compliance	Employers must also ensure that the operation of their NQDC plans complies with Section 409A, including the timing of deferral elections, distributions, and any amendments to the plan

General Summary of Section 409A

A general summary of Section 409A is as follows: U.S. Code § 409A—inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.

(A) Constructive Receipt Rules

Employees can’t have the right to get their deferred money whenever they want. If they can choose to receive it, they’re taxed immediately.

Key Requirements:

• Must decide to defer money before earning it
• Can’t change your mind later about when to get paid
• Must pick specific future dates or events (like retirement) for payout
• No flexibility to speed up payments

(B) Rules Relating To Funding

If the employer sets aside money in a way that protects it from creditors, employees get taxed immediately – even if they can’t access it yet.

Key Points:

• Money must stay at risk with the employer’s general creditors
• Can’t put deferred comp in trusts that protect employees
• Rabbi trusts are OK (creditors can still reach the money)
• Secular trusts trigger immediate taxation

(C) No Inference On Earlier Income Inclusion Or Requirement Of Later Inclusion

Section 409A of the Internal Revenue Code states that compliance with its rules should not infer that deferred compensation must be included in gross income sooner or later under other tax code sections.

Key Points:

• If other tax laws say you owe tax now, Section 409A doesn’t override that
• If other tax laws say you don’t owe tax yet, Section 409A doesn’t force it
• Section 409A only adds its requirements on top of existing rules

(D) Other Definitions And Special Rules

Section 409A of the Internal Revenue Code includes definitions and rules concerning nonqualified deferred compensation plans.

• Specified Employee: Top executives at public companies who must wait six extra months after leaving before getting distributions.
• Separation from Service: When the employment relationship ends.
• Disability: Must meet Social Security disability standards.
• Change in Control: Corporate transactions like mergers with specific ownership thresholds.
• Unforeseeable Emergency: Severe financial hardship from sudden illness, accident, or unexpected events.

Key Special Rules:

• 6-month delay: Specified employees can’t get separation pay for 6 months after leaving.
• Subsequent elections: Very limited ability to change distribution timing – must delay at least 5 years.
• Anti-acceleration: Plans generally can’t speed up payments beyond the original schedule.

(E) Regulations

To implement Section 409A effectively, the Secretary of the Treasury will establish several necessary regulations:

• Corporate Ownership and Control Changes: Set out rules regarding how changes in the ownership or control of a corporation or its assets should be handled, specifically under certain subsections of the law (a) (2) (A) (v).
• Exemption Criteria for Arrangements: Define conditions under which certain arrangements (b) can be exempted from the rules of Section 409A to prevent improper deferral of taxes or assets being placed out of creditors’ reach.

Example for IRC Section 409A

BLUESKY Inc. a fast-rising cloud storage startup known for its AI-powered data security solutions, decides to grant new stock options to its employees.

The company plans to grant stock options to its employees as part of a new incentive compensation plan at a board-determined value of $0.01. In the future, the IRS will investigate this option price and evaluate the business.

Founding Shares FMV (Board Determined)	$0.00
Options Granted	50,000
Options FMV (Board Determined)	$0.01
FMV (409A Valuation Determined)	$0.05
Difference	$0.04
Price Difference (Difference * Options Granted)	$2,000
Tax Penalty	20%
Penalty Amount (Tax Penalty * Value)	$400

• The difference between the incorrect strike price ($0.01) and the current value ($0.05), is $0.04 per share for the 50,000 options received. This would give the total amount of $2,000, even if the employee has exercised the option or not.

• Pay the penalty equal to 20% of the price difference. In this case, 20% of $2,000, which is a $400 penalty, must be paid to the IRS.
• Additionally, if the employee comes under the tax bracket of the 35% income tax rate, they would have to pay a $700 income tax.

So according to IRC Section 409A, the company would need to set the new stock options at $0.05.

IRC Section 409A Mandate

• Section 409A requires private companies like BLUESKY to obtain a 409A valuation to determine their common stock’s fair market value (FMV) before granting stock options or other equity-based compensation.
• This valuation ensures that employees don’t receive preferential tax treatment by purchasing stock at a price below its FMV.

Valuation Process

• BLUESKY engages an independent valuation firm with expertise in 409A valuations.
• The firm analyses BLUESKY’s financial data, business model, industry trends, and recent financing rounds.
• They apply valuation methods like discounted cash flow (DCF) and comparable company analysis to determine the FMV of BLUE SKY’s common stock.
• The firm issues a 409A valuation report stating the FMV per share.

Impact on Stock Option Grants

BLUESKY sets the exercise price of its stock options at $0.05 per share, equal to the FMV

FAQs

Below we listed Frequently asked questions for the IRS 409A:

What are the consequences of not complying with IRC section 409A?

If a company fails to comply with Section 409A, employees and other recipients of stock options face immediate taxation of vested amounts, an extra 20% penalty tax, and higher interest on unpaid taxes. These penalties are paid by the individuals receiving the options, not the company.

What are the reporting requirements for employers under section 409A?

Reporting Amounts Includible in Gross Income under Section 409A, Reporting Nonemployee Compensation, and Interim Reporting Relief. Employers must carefully track and report amounts includible in income under Section 409A on employee W-2s and nonemployee 1099s while being mindful of the specific reporting requirements and deadlines.

How often should a company review its section 409A compliance?

The best practice is for companies to review their 409A compliance at least annually proactively and more frequently if material events could impact the company’s valuation. Maintaining proper documentation and working with qualified 409A experts can help ensure ongoing compliance.

What are the steps to take to comply with section 409A?

The key is proactively reviewing all deferred compensation arrangements, making necessary changes to bring them into compliance, and implementing procedures to avoid operational failures. Seeking expert guidance can help ensure that Section 409A requirements are properly addressed.

What is Safe Harbor in IRC 409A?

409A Safe Harbor means your company’s stock valuation is presumed reasonable by the IRS, protecting you from penalties unless the IRS can prove the valuation is “grossly unreasonable.” The three types of 409A Safe Harbor methods are Independent Appraisal, Binding Formula, and Illiquid Startup presumptions.

What are the documents needed for the 409A valuation?

You need to provide company details, fundraising info, industry data, financial statements, and any material events in your company’s history. Documents required for a 409A valuation help the independent appraiser accurately assess your company’s fair market value.

What valuation methods are used for Section 409A compliance?

The three main 409A valuation methods are the Market Approach (comparing your company to similar public or private companies), the Income Approach (valuing based on expected future cash flows), and the Asset Approach (calculating net asset value).

How can Eqvista’s 409A Valuation Help you?

After reading this article, you now know that a 409A valuation is very important for your company, especially if you are giving out options or taking up new investments. And with all the information provided, you can now make an informed decision about your 409A provider. In fact, Eqvista offers 409A valuation services. We have an expert team ready to help you learn more about the value of your company.

Get in touch with our team and schedule a consultation with our valuation experts. We can discuss your company and how to go about getting a 409a valuation done in no time!