An employer may seek to reward a long-time or key employee for good work by promising to pay a bonus to the employee upon the employee’s retirement. However, an employer that contemplates putting such an arrangement in place should stop and ask itself one fundamental question: Did it remember 409A?
Section 409A of the Internal Revenue Code (or, as referred to here, “409A”) sets strict rules for when an employer may pay nonqualified deferred compensation to its employees or other service providers such as consultants or independent contractors. Nonqualified deferred compensation covers most forms of compensation that will or may be payable after the 15th day of the third calendar month in the year that follows the year in which the compensation is no longer subject to a substantial risk of forfeiture (i.e., the “short term deferral period”). A “substantial risk of forfeiture” is a term defined in 409A. If compensation is subject to a substantial risk of forfeiture, it generally means the payee’s right to receive the compensation has not vested. Significantly, for purposes of retirement compensation, nonqualified deferred compensation does not include compensation payable under a qualified employer plan such as a 401(k) plan, cash balance plan, traditional defined benefit pension plan, or employee stock ownership plan.
For example, if an employer enters into a contract with an employee in 2025 that entitles the employee to receive a $10,000 bonus on June 30, 2027, provided the employee remains employed with the employer through December 31, 2026, that bonus likely constitutes nonqualified deferred compensation subject to 409A. No substantial risk of forfeiture with respect to the bonus exists after December 31, 2026, but the payment date for the bonus occurs after March 15, 2027 (i.e., the 15th day of the third calendar month of the year – 2027 – following the year in which the compensation is no longer subject to a substantial risk of forfeiture – 2026).
Employers can structure compensatory arrangements either to comply with 409A or to be exempt from 409A. In general, 409A-exempt arrangements are more favorable than 409A-compliant arrangements, because 409A compliance requires adherence to a strict and complex set of rules. An employer may determine that the arrangement no longer makes sense from an economic, incentivization or retentive perspective after the employer adopts the arrangement, but the employer will discover that 409A affords little latitude to the employer and employee to amend a 409A-compliant arrangement following its adoption. The employer may then find itself stuck with the original arrangement since breaching 409A subjects the employee to stiff tax penalties: the employee must include the compensation in income for federal income tax purposes at the time the compensation is no longer subject to a substantial risk of forfeiture even if the compensation is not yet paid, and the employee must pay a 20% penalty on the deferred amount plus interest. This tax burden does not fall on the employer, but is not good for employee relations and may well negate the benefit the employer intended to provide. In addition, the employer may find itself exposed to penalties for failure to timely withhold and report income realized by the employee.
Subject to limited exceptions, an employer may pay nonqualified deferred compensation subject to 409A to employees only on certain specified events: (i) the employee’s death; (ii) the employee’s disability; (iii) the occurrence of a change in control event; (iv) the occurrence of an unforeseeable emergency; (v) at a specified time or in accordance with a fixed schedule; or (vi) upon the employee’s separation from service. Each of these permissible payment events is specifically defined in the 409A statute. An employee’s retirement likely qualifies as a permissible payment event under 409A as a separation from service. However, if after retirement, the employee continues to provide services to the employer, the retirement might not meet the requirements of a 409A separation from service, since the retirement must be a separation from service as defined by 409A. Employers should therefore continue to engage retired individuals cautiously with an eye to how much post-retirement service they perform relative to the 409A requirements.
An employer that wishes to establish a compensatory arrangement that entitles an employee to 409A-exempt payment upon retirement must carefully craft such an arrangement to meet 409A’s detailed requirements for exemption. For example, an employer may want to implement an arrangement that provides that an employee is entitled to a bonus upon the employee’s retirement after reaching the age of 65 and providing 10 years of service. However, this arrangement will likely need to comply with 409A. This is because the employee’s right to the bonus becomes substantially non-forfeitable when the employee turns 65 and achieves 10 years of service, but the employee may not retire until a date that is later than the 15th day of the third calendar month following the year the employee is 65 and has 10 years of service (i.e., after the end of the short-term deferral period).
In contrast, an arrangement that pays out on or shortly following the date the employee turns 65 and achieves 10 years of service, whether the employee also retires on such date or does not retire, will likely be exempt from 409A as the payment is made within the short-term deferral period. However, if this arrangement pays out in installments rather than in a single-lump sum following the date when age 65 and 10 years of service is reached, than this arrangement may also need to comply with 409A.
Taking a pause in the roll-out of retirement compensation arrangements and considering the possible applicability 409A is very important. Both the employer and employee will be grateful later on when the arrangement does not need to comply with the burdens of 409A or when the arrangement must comply with these burdens but does so correctly.
Note, this is a high-level overview of 409A’s applicability to such retirement arrangements and individual circumstances may vary. Employees and employers should consult with their tax advisors for additional information about what 409A requires.