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Employers discuss Section 409A deferred compensation plans and penalties.

Proposed change would require employers to withhold 409A penalties on failed NQDC plans

August 14, 2023 / 2 min read

A new proposal would require employers whose 409A deferred compensation plans that have been found deficient to withhold 409A penalties from employee pay.

Deferred compensation arrangements covered by Internal Revenue Code (Code) Section 409A, commonly referred to as “nonqualified deferred compensation plans,” “409A plans,” or “NQDC plans,” offer employers and executives various advantages when it comes to flexibility in structuring salary and benefits, but they also carry some risks. Under current law, the IRS can assess penalties against the employee if an NQDC plan fails to meet the requirements of Section 409A. A Section 409A failure results in accelerated tax along with an additional 20% tax and interest (Section 409A penalties).

While it has long been understood that an employer has an obligation to withhold applicable income and payroll tax on amounts required to be included in wages due to a Section 409A violation, Code Section 3402(a), which imposes the withholding requirement on employers, doesn’t include Section 409A penalties. Accordingly, under current law, the IRS would need to collect Section 409A penalties from the affected employees.

Each year, the president proposes various Code updates to Congress as part of the administration’s fiscal year revenue budget (also known as the “Greenbook”). For two years running, the Biden administration has proposed modifications to Section 3402(a), which would change the status quo by requiring employers to withhold from an employee’s pay the Section 409A penalties resulting from a failure. This proposal would be effective beginning in 2024.

To be clear, this is only a proposal in the president’s budget plan at this time, and the proposal wouldn’t require employers to pay the Section 409A penalties. The modification to the 409A penalty collection rules hasn’t yet passed either house of Congress. Even if it does pass without any amendment, the employee would still be liable for the penalties, but it could pose challenges to employers where violations are discovered after the fact, maybe even after an individual is no longer employed.

This is only a proposal in the president’s budget plan at this time, and the proposal wouldn’t require employers to pay the Section 409A penalties.

If enacted, this proposal would require employers whose NQDC plans fail to meet Section 409A to withhold the Section 409A penalties owed by the employee from that person’s pay and remit that withholding to the government. Affected employers who fail to comply with the proposed withholding requirements could still see a tax impact at the business level, however, in the form of failure-to-withhold penalties. To make matters worse, the employer would be responsible for calculating the Section 409A interest, which even the IRS has acknowledged is a complex calculation — many employers would likely struggle to get the calculation right.

409A deferred compensation plan compliance is always complex

Whether this new proposal becomes law or not, employers can always benefit from a 409A compliance review at least every other year to take full advantage of the IRS correction programs. Most businesses that find and correct a 409A compliance error on their own fare much better than those whose NQDC plans are found to be deficient in an IRS audit. The IRS has a correction program that can minimize or even eliminate error penalties if they’re identified and corrected within two years of the error.

To stay abreast of the latest news on this proposed change and other developments in compensation and benefits, please subscribe to Plante Moran’s Perspectives email alert service. To learn more about how your business could benefit from a 409A compliance review, please contact your Plante Moran engagement team.

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