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Is it an Employment Agreement or a Deferred Compensation Plan? It could be both.

By D|K’s Labor and Employment Team

Deferred compensation rules under Internal Revenue Code Section 409A cover a broad range of post-employment payment arrangements.

Do you have a deferred compensation plan hiding in an employment contract or employee handbook?

Internal Revenue Code Section 409A provides detailed rules applicable to deferred compensation plans, including those that cover public employees. Many employers (both public and private) assume that the use of the word “plan” means that Section 409A only applies to formal arrangements involving multiple employees, such as non-qualified salary deferral programs and (for public employers) Code Section 457 plans. However, Section 409A also specifically includes deferred compensation arrangements that cover only one person.

Under Section 409A, compensation is considered deferred when an employee earns or acquires a legally binding right to receive the compensation in one tax year but is not paid until a later tax year. For example, suppose that an employer enters into an individual employment agreement which provides that an employee will receive $100,000 paid in 24 monthly installments beginning in the month following the individual’s termination of employment. Once employment terminates, the employer is contractually required to pay the full $100,000, but the employee will not receive all of it until future years. As a result, compensation is considered deferred under Section 409A.

Additionally, installment payments made to former employees pursuant to an employee handbook or policy (whether written or not), may constitute a deferred compensation arrangement that is subject to Section 409A, unless it qualifies as a severance benefit payable when an employee is involuntarily terminated.

Once payments become subject to Section 409A, they must comply with the Code’s requirements for deferred compensation plans. These include:

  • A written document that includes specific provisions.
  • Limits on distributions until the occurrence of specified events, such as a separation from service, disability or death.
  • Complying with timing rules for changes in payment schedules.

If a deferred compensation plan does not satisfy the requirements of Section 409A, the individual (and not the employer) faces payment of a 20% penalty tax on the amount deferred, plus potential late-payment interest penalties. Although the employer is not liable for the tax penalties related to non-compliance, it has a practical interest in avoiding claims for reimbursement, as well as employee relations issues, related to Section 409A.

If an employer, like the one in the example above, discovers an employment agreement or benefit policy that includes deferred compensation payment but not all of the written provisions required under Section 409A, it may be able to take advantage of the IRS Documentary Correction Program. The Program allows employers to correct certain types of Section 409A failures, including those related to plan documentation. In order to be eligible for the Program, however, the arrangement must have complied with Section 409A in operation.

The moral of the story is that both public and private employers should review any current individual employment arrangements to determine if: (1) they include post-termination payment provisions, and (2) whether those arrangements are subject to and comply with Section 409A.

If you have any questions regarding this article, please contact your Davis & Kuelthau attorney, or our Labor and Employment practice chair linked here.