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409A Penalties And Compliance: 409A Valuation Overview

409A Penalties and Compliance: 409A Valuation Overview

Want to learn how to avoid 409A penalties? Good, you’re in the right place!

Nothing jeopardizes the stability of your growing company like having the IRS down your throat. But if your company doesn’t comply with Section 409A of the Internal Revenue Code, that’s exactly where they’ll be. The IRS doesn’t mess around when it comes to 409A non-compliance. You have Enron to thank for that. If you offer non-qualified deferred compensation to your employees, you should be justifiably paranoid about your 409A.

Non-Qualified Deferred Compensation

Recall that for 409A compliance, an independent company valuation is required for non-qualified deferred compensation (NQDC) plans that include stock options and/or stock appreciation rights (SARs). The valuation establishes the strike price at which the options and SARs can be exercised. Compensation in a NQDC plan:

  • Is legally binding.
  • Is payable in a later tax year.
  • Is taxable in a later tax year.
  • Cannot (in most cases) be accelerated.
  • Is subject to vesting or performance requirements.
  • Does not include short-term deferrals (i.e., deferrals up to 2 ½ months).

409A Penalties for Not Satisfying Compliance Rules

The IRS is not playing games with 409A compliance. The penalties will ruin your employees before they ruin your business, but you can bet one follows closely after the other. Employee tax penalties for 409A non-compliance include:

  1. Employees must pay income tax and a 20% penalty on all deferred vested amounts under the NQDC plan as of the last day of the vesting year, even when payment occurs in subsequent years.
  2. Employees must also pay a premium interest tax of 1% above the federal underpayment penalty rate on failed compensation from the vesting date forward. 
  3. Employees may be forced to pay additional penalties stemming from the understatement of income.
  4. Employees may also be liable for state-imposed penalties.

Employer Withholding

If your 409A valuation is found to be non-compliant with the Internal Revenue Code employers will be subject to withholding taxes on the vested deferred compensation piece of employees’ earnings. If employees don’t receive (actually or constructively) their deferred compensation, the IRS will deem it to be included on December 31 of your taxable year of failure. Fortunately, withholding taxes don’t apply to the 20% penalty or premium interest tax.

Plan Aggregation

If an operational failure occurs, the IRS can tax and penalize all your NQDC arrangements subject to 409A regulations. This covers supplemental executive retirement plans (SERPs), salary deferral plans, severance agreements, executive employment agreements, and unwritten bonus programs. One bit of good news: if you have more than one set of NQDC stock options or SARs, the fact that one set is found to be in violation of IRC 409A does not automatically cause failure of your other NQDC stock options and SARs.

Correcting Stock Option and SAR Failures Under 409A

One of the major triggers of IRS action is when stock options or SARs issued at a discount—with a strike price below the FMV on the grant date—become vested. In fact, that is precisely what a 409A valuation is supposed to prevent. In 2015, the IRS clarified that correcting the failure in the year of vesting but before the vesting date was not good enough. Instead, the discrepancy must be corrected in the year prior to the vesting year. Employers can generally correct a stock option or SAR by resetting the stock price to the appropriate amount. Lawyers have argued over whether the appropriate amount is the correct strike price on the reset date rather than the correct strike price on the original grant date.

Best Practices for 409A Compliance

For a NQDC plan to comply with Section 409A, it must understand and follow the rules outlined in the Internal Revenue Code. Common rules, standards, and best practices include:

  • A “permitted event” must be identified to trigger payment of NQDC stock options or SARs. This could mean reaching a specific date or performance requirement (e.g., reaching a profit goal). The date requirement is associated with the date in which employees received their vested deferred compensation. Permitted events may also be related to company performance, like .
  • One common permitted event is “separation from service”. However, key company officers must wait six months after termination before receiving their payouts.
  • Other permitted events include disability, death, unforeseen emergencies, and changes in company control.
  • The plan must disallow illegal early or delayed payments. Securities cannot be replaced after they have been awarded. This means you can’t swap options for appreciation rights or for options at a different strike price.
  • The employer must report the amount deferred each year on Form W-2 or Form 1099.

If you want to avoid an IRS audit, we suggest you sidestep these mistakes:

  • Allow participants to speed up their NQDC payouts.
  • Mismanage NQDC forfeitures. These occur when participant want to reduce their NQDC payouts.
  • Allow employees to trigger NQDC payouts by changing status from full-time to part-time without accounting for the regulations that define separation.
  • Allow participants to delay their NQDC payouts without accounting for the rules permitting delays.
  • Use an option or SAR strike price below the company’s fair market value.

Reviewing Non-Qualified Deferred Compensation Plans for 409A Compliance

Even after you think you’ve achieved a safe harbor 409A valuation, you can’t go wrong by double-checking. Regularly reviewing your non-qualified deferred compensation plans helps ensure you’ve crossed your t’s and dotted your i’s. Not only does this reduce the risk of missing something on your valuation, it helps you maintain compliance with IRC 409A moving forward. While reviewing your non-qualified deferred compensation plans, pay close attention to these five areas of concern:

  1. Initial deferral election,
  2. Payment timing,
  3. Payment acceleration,
  4. Payment re-deferral, and
  5. Fair market value of the company.

Initial Deferral Election

Employees must elect to receive deferred compensation in the year before the calendar year in which they begin providing services to the company. This means you must elect, in 2019, to defer compensation for services performed in 2020. The rules are a little different for newly eligible employees. This typically describes one of two cases:

  1. Cases in which a company implements deferred compensation offerings for the first time.
  2. Cases in which a previously unqualified employee becomes eligible to participate in a non-qualified deferred compensation plan.

For newly eligible employees to elect deferred compensation for the first time (in the middle of a calendar year), they must make their elections within 30 days of becoming eligible. Their elections apply only to compensation earned for services performed after the election date. These rules do not apply to employees who chose not to participate in NQDC plans which had previously been available to them. Because of this, newly eligible employees are often those who have been recently hired or promoted. It should be noted that the rules regarding newly eligible elections do not apply to cases in which the employer’s existing NQDC plan is being replaced with a new one.

409A Compliance: Payment Timing, Acceleration, and Re-Deferral

The timing of payments in non-qualified deferred compensation plans plays an important role in 409A compliance. There are six major triggers that initiate a payout:

  1. Death
  2. Disability
  3. Unforeseeable emergency
  4. Change in company control
  5. Predetermined time or payout schedule
  6. “Separation from service” (e.g. retirement, termination, resignation, etc.)

These triggers are described in detail in IRC 409A(a)(2)(A). There are two rules which pave the way for flexibility when handling payouts. One allows for payouts within a predetermined period of time. This predetermined period must be objectively determined and meet one of the two following conditions:

  1. The payout is made in the year following the completion of services (between the first and last day of the following calendar year).
  2. The payout is made any time within 90 days after the trigger event and the service provider is not permitted to choose the tax year of compensation received.

Your NQDC plan must explicitly deny “haircuts”, which are accelerated payouts of a reduced amount. The plan should carefully distinguish between prohibited haircut provisions and acceptable provisions for employee forfeiture of payments. In general, Section 409A prohibits payment acceleration, therefore—unless subject to a very narrow set of exceptions—your NQDC plan must do so as well.

Employees may re-defer compensation. This is generally used as a strategy to save for retirement. Retired employees are taxed once they’re no longer receiving a salary and, therefore, are often in a lower tax bracket. Your NQDC plan must recognize the conditions employees must meet to qualify for payment re-deferral. The first payment must be deferred for at least five years except when disability, death or an unforeseen emergency occurs. There must also be a period of at least 12 months before the re-deferral can take effect. This includes payments at a specified time or fixed schedule.

Fair Market Value in 409A Valuations

Every employer offering non-qualified deferred compensation is required to submit a 409A valuation. This means appraising the fair market value of the company. Regardless of whether or not you aim to achieve a safe harbor 409A valuation, you should ensure the firm performing your valuation operates independently. The IRS is on the lookout for companies manipulating strike prices to gain an unfair advantage. Sometimes, companies aren’t even aware that the independence of their valuation provider has been compromised. This can occur when a company packages their valuations in with their equity or cap table management software. Software providers often partner with firms providing fair market value appraisals, as the opportunity to share information can streamline the 409A valuation process. However, even the leading cap table software providers jeopardize their clients’ 409A compliance by bringing valuation services in-house, operating a valuation firm as a subsidiary, or otherwise fostering a conflict of interest. To make sure your 409A valuation remains above board, ask your 409A valuation or cap table software providers about any relationships which may present a conflict of interest. They should offer nothing short of enthusiastic transparency on this front. If their answer is not short, simple, and straightforward, it warrants a deeper investigation. Another rule of thumb supporting 409A compliance: if the services a valuation firm offers are suspiciously affordable, chances are there’s something worth being suspicious about.


Paying close attention to your 409A valuations and non-qualified deferred compensation plans to ensure they’re in compliance with IRS regulations is a lot of work. At the same time, the time and money you spend on compliance outweigh the penalties. It’s not just your company that will suffer the consequences. Your employees risk having their lives upturned. No one wants to work for a company that puts their financial well being at risk. To read more about safely performing a 409A valuation, visit the Diligent Equity blog. To learn about EquityEffect’s cap table management software and partnerships with fully-independent 409A valuation providers, request a demo today.

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