Six Permissible Payment Events under Section 409A

Non-compliance with Section 409A of the Internal Revenue Code (IRC) can trigger significant financial consequences for service providers, including immediate taxation of vested deferred income, higher-than-normal interest on unpaid taxes, and a 20% penalty tax.

A common violation of Section 409A is paying out deferred compensation plans without following the non-acceleration and deferral rules of Section 409A. Hence, in this article, we will dive deeper into 409A permissible payment events to help you safeguard yourself and your employees from costly errors. Read on to learn more!

409A permissible payment events for deferred compensation

Employers and employees involved in nonqualified deferred compensation arrangements under Section 409A must understand and comply with the permissible payment events. The payment of deferred compensation plans is permissible in the following six events.

Specified time or fixed schedule

Payment schedules or formulas defined at the time of deferral are the prime 409A permissible payment events. Any schedule changes must follow the non-acceleration and deferral rules specified under Section 409A.

The payment schedule or formula must be something that can be objectively interpreted and cannot be manipulated by the service provider or the service receiver.

For instance, payments scheduled upon a merger or acquisition are not permissible since this is not a predictable event. However, an employee receiving 1% equity at the end of the calendar year is a 409A permissible payment event.

A deferred compensation plan that links the payment timing to the employee’s income is permissible if:

• Payments come from routine and legitimate business activities that are a part of the business’s regular operations
• The service provider or service receiver cannot influence the payment owed or the timing of the payment
• Method for establishing the payment and its schedule is objectively defined
• Payments are calculated based on all frequent sales unless legitimate non-tax reasons exist for excluding some sales

Separation from service

When a service provider separates from an employer, they can receive deferred compensation payments. However, there are certain caveats to this payment event. A six-month delay post the separation date is applicable if the service provider was a key employee. Section 416 of the Internal Revenue Code defines key employees as:

• Officers with annual compensation higher than $130,000
• 5% owners
• 1% owners receiving annual compensation higher than $150,000 from the employer

This rule does not apply to service providers who are not key employees. Another important exception is that if a person was not a key employee on the separation date but could have become one post the date of separation had the separation not happened, the six-month delay is not applicable.

Conversely, if someone was a key employee on the separation date but would not maintain that status post-separation, the six-month delay is applicable.

The requirements of Section 409A are met if each payment that was previously scheduled in the six months since the separation date is delayed by six months. These requirements are also met if all scheduled payments in the six months since the separation date are held off until at least the first day of the seventh month since separation.

Disability

If a service provider suffers a disability and certain conditions are met, the Section 409A permits payments of deferred compensation. A person is considered disabled if they meet the following conditions:

• Inability to engage in work that generates significant income
• Mental or physical impairment expected to last for at least 12 months or result in death
• Receipt of disability income via income replacement plans for at least three months

The deferred compensation plan may propose a definition of disability that is at least as broad as the one mentioned in Section 409A. For instance, a plan may define disability as impairments expected to last at least 24 months instead of 12 months but not 6 months.

The disability will qualify for deferred compensation payments if government agencies such as the Social Security Administration declare the service provider as disabled. If the employer finds that the disability meets the definition in disability insurance plans and the requirements of Section 409A, then too the disability will qualify the service provider for deferred compensation payment.

Death

It is a 409A permissible payment event for deferred compensation plans when the service provider dies. Upon death, the deferred compensation can be paid anytime during the period that begins on the date of death and ends on the last day of the first calendar year after the year of death.

Additionally, payments can be accelerated if the beneficiary suffers a disability, dies, or faces unforeseeable emergencies.

Change in control

When a change in control event occurs, it is a 409A permissible payment event. Three types of change in control events are considered in Section 409A and they are defined as:

Change in control event	Description
Change in ownership	A person or group acquiring more than 50% of the corporation’s stock value or voting power through events such as stock buybacks or stock purchases
Change in effective control	A person or group acquiring at least 30% voting power within 12 months of payment Majority of the board of directors being replaced within 12 months without prior endorsement
Change in ownership of substantial assets	A person or group acquires at least 40% of the total assets by value

The change in control event must meet a specific criterion defined in the deferred compensation plans and cannot be recognized based on an individual’s opinion.

Furthermore, the change in control event is relevant if the corporation where it happened was directly employing the service provider or was the parent company (more than 50% ownership) for the service receiver.

Any other corporation that was responsible for paying the deferred compensation is also considered a relevant corporation as long as there is a valid business reason for the setup other than tax avoidance.

Here you must note that transfers to related parties such as subsidiaries do not count as change in control events.

Unforeseeable emergency

When a service provider experiences an unforeseeable emergency such as damage to primary residence due to wildfires, medical issues, or emergencies affecting the service provider’s spouse, dependent, or beneficiary, Section 409A allows for the payment of deferred compensation. However, these payments must be limited to the amount necessary for addressing the emergency.

If the service provider participates in multiple deferred compensation plans, the specific plan that will be paid out must be identified at the time of payment.

Also, before the payment of deferred compensation is considered, alternatives such as insurance reimbursements, liquidation of assets and even stopping the deferral of payments to receive compensation when accrued must be considered.

A service provider can choose whether to request the payment of deferred compensation to deal with an emergency and the employer can decide whether to approve the payment based on the plan’s rules. Not requesting a payment is not treated as a decision to further defer income.

You must note that foreseeable emergencies such as home loan payments and education loan payments do not qualify as unforeseeable emergencies. However, if an unforeseeable event causes financial hardships such as being unable to make home loan and education loan payments, it will be considered an unforeseeable emergency under Section 409A.

Eqvista – Compliance made easy!

Adhering to 409A permissible payment events is crucial for ensuring compliance with tax regulations. Unless events such as death, disability, unforeseeable emergencies, change in control, or separation occur, you must adhere to the predefined payment schedule and formula. Even when such events occur, you must follow various guidelines prescribed in Section 409A to ensure tax compliance.

Another important aspect of tax compliance when issuing equity compensation is establishing the fair market value (FMV) through 409A valuations. At Eqvista, we enable companies from various stages to qualify for safe harbor provisions at affordable prices and rapid turnaround times. Contact us to learn more about our service!