What is IRC Section 409A?
In 2005, the IRS issued the Internal Revenue Code (“IRC”) Section 409A. This section regulates the treatment of deferred compensation (compensation that workers earn in a specific year but that is paid in a future year) for federal income tax purposes. IRC 409A imposes tax penalties if violations occur.
Definition of IRC Section 409A
Section 885 of the American Jobs Creation Act of 2004, Pub. Law No. 108-357, 118 Stat. 1418 (the Act), added Section 409A to the Internal Revenue Code.
From the IRS website, “§409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan”.
IRC 409A regulations were finalized with an effective date of January 1, 2008 but is generally effective with respect to amounts deferred after December 31, 2004.
Scope of application for IRC Section 409A
IRC 409A provides that all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income – to the extent not subject to a substantial risk of forfeiture (i.e. compensation not vested) and not previously included in gross income.
With regards to common stock option grants, under IRC 409A an employee who is granted stock options might be subject to income taxes in the year the employee’s stock options vest, depending on the fair market value of the underlying common stock.
Before IRC 409A, the employee would be subject to taxes based on the amount the fair market value exceeded the exercise price of the option when he/she exercised the option.
Penalties of IRC Section 409A
If the deferred compensation complies with the requirements of IRC Section 409A, then there is no effect on the employee’s taxes.
Failure to comply with IRC 409A can result in the following penalties:
- Taxing the deferred compensation at the ordinary income tax rate level for each year in which the amount was deferred, plus
Requirements for stock options under IRC Section 409A
IRC 409A requires a common-stock valuation to determine the amount of the deferred compensation subject to income taxes.
How can you perform a 409A valuation?
You don’t want to pay the heavy fees to hire a third-party specialist, so can you do it in-house? According to IRC 409A, yes you can. The “illiquid start-up” appraisal indicates that a person within your firm can perform a valuation as long as the fair market value conclusion is “reasonable” and the person performing the valuation has “significant knowledge and experience or training in performing similar valuations”.
The option to do this valuation in-house is now available, and a lot of money could be saved if equipped with the proper tools.
Click HERE to discover how we can help you perform your own 409A valuation.