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409A compliance: Errors, penalties, & corrections

April 24, 2023 / 2 min read

While nonqualified deferred compensation plans are great vehicles to attract and retain staff, they come with challenges — in the form of something called Internal Revenue Code Section 409A. Here’s what you need to know when you identify Section 409A errors.

A nonqualified deferred compensation plan can help attract and retain your key staff in today’s competitive economy. However, compliance with Internal Revenue Code Section 409A can be complicated, the penalties are extremely punitive, and the IRS has no policy to negotiate settlements. Here are a few things to keep in mind as you navigate 409A compliance.

Common Section 409A errors and penalties

Companies tend to make a number of errors when it comes to Section 409A compliance, including:

Unfortunately, with errors come significant penalties, including:

Fortunately, the IRS has a correction program that can minimize or even eliminate Section 409A penalties — if they’re identified and corrected within two calendar years following the error. So, don’t wait; the longer you wait, the greater the possibility of an IRS audit and the less likely penalties can be abated.

Fortunately, the IRS has a correction program that can minimize or even eliminate Section 409A penalties.

Cost savings with Section 409A error correction

Imagine a biotechnology company with a nonqualified deferred compensation plan whose research manager has a $500,000 aggregate plan account balance. The research manager received a payment from one account with a value of $50,000 in a year earlier than elected. The following table illustrates the dramatic difference in penalties and filing requirements, depending on if and when an error is proactively addressed (assuming a 2% AFR rate):

Chart explaining 409A Compliance 

For each correction in the scenarios above, the employee must pay the approximate IRS penalty in addition to repaying the accelerated payment — in our example, $50,000 — back to the employer. If the employee can’t repay the $50,000, then the error wouldn’t be eligible for correction, and the entire $500,000 plan account balance would be taxed.

The corrections, approximate penalties, and additional filing requirements are similar where the error involves a late payment of an amount payable in an earlier year. However, as the penalties require immediate income recognition of the participant’s entire plan balance, deferral errors generally have higher penalties where the error isn’t proactively corrected. In our example, the approximate penalty for a deferral error would be $500,000.

If the research manager was an officer, director, or 10% owner of the biotechnology company, then the penalties could be even higher under both the acceleration and deferral error.

Contact our authors

Uncovering errors and navigating through the correction procedure can require help from a trusted expert. Our 409A specialists can help you meet regulatory compliance. Questions? Reach out to our team — we’re here to help.

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