Application of Code Section 409A to Employment Relationships: Tax Law Meets Employment Law

All uses of the term Section, unless otherwise noted, will be references to sections of the Internal Revenue Code of 1986, as amended.

A more thorough analysis of the provisions contained in Section 409A, although no doubt stimulating, is beyond the intended scope of this article.

The Internal Revenue Service issued final regulations under Section 409A in April 2007, and the discussion in this article conforms to those final regulations.

The Internal Revenue Service will examine the facts and circumstances to determine whether the discretion to reduce or eliminate the compensation lacks substantive significance. The employee will have a legally binding right to compensation if the negative discretion is exercisable only on a condition or if the employee has effective control over, or is a member of the family of, the person who has discretion over the payment.

Technically, the rule requires that the payment be made by the 15th day of the third month following the later of the end of the employee's tax year during which the payment was earned or the end of the employer's tax year during which the payment was earned. As a result, complications may arise in situations in which the employer's tax year is not the calendar year. Treas. Regs. §1.409A-1(b)(4)(i).

Payments that miss the short-term deferral deadline will continue to be treated as short-term deferrals if (a) it was administratively impracticable to make the payment by the end of the short-term deferral period, (b) either the impracticability was unforeseeable as of the date the legally binding right arose or making the payment would have jeopardized the ability of the service recipient to continue as a going concern and (c) payment is made as soon as administratively practicable or as soon as the payment would no longer have such effect. An employee's action or failure to act (such as failure to provide necessary information) is not an unforeseeable event.

Special exemptions also exist for separation pay arrangements that are collectively bargained as well as those arrangements under “window” programs of limited duration.

For example, business expense reimbursements and benefits under a nondiscriminatory self-funded health plan are nontaxable and not subject to Section 409A. However, health and welfare benefits that are available only to highly paid employees are taxable and must conform to the requirements for reimbursements under Section 409A.