Sections 409A and 162(m) of the Internal Revenue Code: Top Compliance Pitfalls

16 Min Read By: Joseph M. Penko


  • A company’s compensation arrangements must not only meet its desired business needs, but also comply with the applicable complex and often counterintuitive IRC rules.
  • Sections 409A and 162(m) in particular contain many technical, complicated rules that continue to challenge companies in developing and maintaining their compensation programs.
  • Understanding the key pitfalls and other traps for the unwary regarding these sections and having specific procedures in place to avoid unintentional failures that result in unintended consequences and penalties is key.

The early part of the year is a time during which many companies and their compensation committees, management teams, and outside advisors are focused on both developing new compensation arrangements and reviewing existing compensation arrangements for executives and other employees. These arrangements must be structured and maintained in a way that not only meets the company’s desired business needs, but also complies with the complex and often counterintuitive rules contained in various applicable sections of the Internal Revenue Code.

Two sections of the Internal Revenue Code that continue to challenge both companies and their advisors in creating compensation arrangements are Section 409A, which governs the treatment of nonqualified deferred compensation arrangements, and Section 162(m), which limits the annual compensation deduction that a public company may take with respect to certain of its executive officers. This article highlights some of the key pitfalls and other traps for the unwary that can cause unintentional failures and result in unintended consequences and penalties under these two sections.

Section 409A

Section 409A contains a comprehensive set of requirements that govern the broadly defined universe of so-called nonqualified deferred compensation arrangements. Violations of Section 409A, whether documentary or operational, can result in significant monetary penalties for the employees and executives who are parties to these arrangements.

While many companies have gained significant familiarity with Section 409A over the past 10 years, the 2014 announcement by the Internal Revenue Service that it has begun auditing Section 409A arrangements has put enhanced pressure on the need to ensure that all arrangements are in compliance with Section 409A. This makes it even more critical that companies and their advisors place extra emphasis on developing procedures for identifying potential Section 409A risks and ensuring compliance with Section 409A rules, to avoid the taxes and penalties that can result from even innocent mistakes.

The following sets forth some of the main Section 409A compliance issues frequently encountered in practice.

General Application of Section 409A

One reason for many inadvertent violations of Section 409A is the failure to identify that the arrangement at issue is subject to its requirements. This happens because Section 409A applies to a wide variety of arrangements that may not be thought of as providing for deferred compensation. Section 409A covers not only traditional deferred compensation arrangements involving the deferral of salaries and bonuses, but also many employment, change in control, and severance arrangements, awards of phantom stock, deferred shares and restricted stock units, and bonus payments. In addition, and unlike some other sections of the Internal Revenue Code, Section 409A is not limited to public companies or certain high-ranking or highly paid executives. Rather, Section 409A applies to both private and public companies and to nearly all service providers, including executives and other employees, nonemployee directors, and most independent contractors. As a result, nearly every compensation arrangement must be examined to determine if it is potentially subject to Section 409A.

The application of Section 409A also is not limited solely to individuals providing services in the United States, but instead has a broad reach that extends to certain foreign deferred compensation arrangements. Section 409A applies to all income payable to United States taxpayers, regardless of the country in which the compensation is earned, unless an exemption applies. For this purpose, U.S. taxpayers include U.S. citizens, legal permanent residents (i.e., green card holders), and temporary residents (as determined by the “substantial presence” test under the Internal Revenue Code). However, for nonresident aliens, deferred compensation is generally subject to Section 409A only if the underlying services were performed in the United States.

In light of the potential reach of Section 409A to foreign arrangements, companies should take action to:

  • perform a thorough review of their employee population, to identify all employees who are U.S. taxpayers,
  • identify all foreign benefit arrangements applicable to U.S. taxpayers that could provide for deferred compensation under Section 409A, and
  • determine whether, in each case, an exemption applies to the particular foreign deferred compensation arrangement, such as arrangements that may be covered by a tax treaty.

Timing of Initial Deferral Elections

The initial election to defer the payment of nonqualified deferred compensation must be made in compliance with a detailed set of rules in Section 409A. In general, an initial election to defer compensation must:

  • be in writing,
  • be irrevocable,
  • specify a payment date or event that is permissible under Section 409A, and
  • be made prior to the beginning of the year in which the compensation is earned.

The final rule noted above regarding the timing of the election continues to create issues for companies and their advisors, because the timing deadline is often counterintuitive. For example, assume that an employee would like to defer a portion of his or her 2016 base salary and a portion of the annual bonus that will be paid to him or her in early 2016 in respect of that person’s performance in 2015. The base salary deferral must be made by December 31, 2015, because it relates to compensation that will be earned in 2016. The annual bonus deferral, on the other hand, generally must be made by December 31, 2014, because while the payment of the bonus will not be made until 2016, the bonus itself was earned in 2015. This is the case even if the bonus is paid by the company on a purely discretionary basis.

Limited exceptions to these general rules are available for certain deferrals, but they are complex and can be difficult to apply, so a careful review is necessary before applying them to a specific situation.

Equity Awards

Section 409A contains exemptions for certain kinds of equity awards, but not for others, so extra care must be taken to ensure that equity awards are structured in a way that is either compliant with or exempt from Section 409A.

Section 409A generally does not apply to restricted stock, partnership interests (including profits interests), or stock options or stock appreciation rights (SARs) that are granted with an exercise price that is at least equal to the fair market value of the underlying stock on the grant date. However, if stock options or SARs have an exercise price that is less than the fair market value of the underlying stock on the grant date, then Section 409A will apply, and the award must be carefully structured in a manner that complies with the applicable Section 409A rules (for example, by limiting the exercise period to a single year).

Restricted stock units (RSUs) are a common type of equity award that are not specifically exempt from Section 409A. While an RSU that is paid out only upon vesting is exempt from Section 409A under its short-term deferral exception, some common design elements may result in an RSU which is subject to Section 409A. These include accelerated vesting upon retirement or upon termination of employment for “good reason,” where good reason is defined in a manner that does not meet the Section 409A standard for treatment as an involuntary termination, or continued vesting following retirement or other termination of employment, including during a post-termination noncompetition period.

RSUs subject to Section 409A are afforded far less flexibility than RSUs that are exempt under the short-term deferral exception. For example, RSUs that are subject to Section 409A:

  • must be paid only on permissible payment events (such as a fixed payment date or payment schedule),
  • must define terms, such as change in control or disability, in a manner that complies with Section 409A, and
  • generally cannot have payment accelerated, although vesting may be accelerated.

To identify RSUs structured in a manner that subjects them to Section 409A, companies should review all agreements and arrangements that may contain provisions applicable to RSU awards. Often, termination terms applicable to RSU awards, and other equity awards, are contained in employment agreements or change in control agreements, so it is critical to review all arrangements that may potentially impact the terms of RSUs. Once all applicable agreements and arrangements are identified, the terms must be carefully reviewed to ensure compliance with Section 409A.

Separation from Service

Separation from service is a permissible payment event under Section 409A, but not all events that would generally be considered to result in the separation of an individual’s service from his or her employer will qualify under the section rules, so care must be taken to ensure that a qualifying separation from service has occurred before making the payment of nonqualified deferred compensation to a service provider as a result of the separation.

For employees, a separation from service generally occurs on the date the employer and employee reasonably expect that the employee’s level of services will be reduced by at least 80 percent from the employee’s average service level for the trailing pretermination three-year period. Although this definition clearly includes a complete cessation of services, it is also mandatory that a continuing service level of 20 percent or less be treated as a separation from service. As the test is based on service level and not employment status, treatment as an employee or independent contractor on an ongoing basis does not change the analysis. Determinations regarding expected future services must be made based on the reasonable expectations of the parties, which may or may not turn out to be accurate. In the event that the reasonable expectations of the parties turn out not to be accurate, there are rebuttable presumptions to evaluate actual service levels in connection with separation from service determinations, including that a service level in excess of 50 percent of the trailing three-year average will presumptively indicate that a separation from service has not occurred, and an 80 percent or more reduction in service level will presumptively indicate that a separation from service has occurred.

For an independent contractor (including a nonemployee member of the board of directors), a separation from service occurs upon a complete termination of the contractual relationship. In general, a continuing contractual relationship, even if under a different status (for example, a change in status from outside director to consultant), will delay separation from service until the good faith, complete termination of all contracts for services with the independent contractor. However, if an individual who serves as both an employee of a company and a member of the company’s board of directors terminates employment with the company, the individual’s continuing service as a director will generally be disregarded for purposes of determining whether the individual has incurred a separation from service.

The separation from service rules can be unexpectedly complex and it is therefore critical to use extra caution to ensure that a separation from service has occurred before making the payment of nonqualified deferred compensation to a service provider as a result of the separation.

Payments Conditioned on a Release of Claims

Many severance arrangements require a terminating service provider to execute a release of claims before the underlying severance payments will be made. The period of time that the service provider is given to consider the release before signing it may make an otherwise exempt arrangement subject to Section 409A, and therefore care must be taken to avoid creating the unintended consequence of a Section 409A failure.

The IRS has clearly indicated in Section 409A corrections guidance that it views as problematic a plan provision that provides for payment following execution of a release if the requirement may effectively allow a service provider to influence the year of payment through the timing of delivery of a release. Even in situations where the employer has not committed to a particular time frame for payment, other than to specify a Section 409A, compliant payment period and to make payment subject to delivery and non-revocation of a release, the IRS has indicated that these provisions may trigger a documentary violation under Section 409A unless the plan terms preclude the service provider from influencing the year of payment.

The two principal ways to address this issue are to provide that either payment will always be made on a fixed date following the date of termination, subject to the earlier delivery and non-revocation period (e.g., 60 days following termination), or, where the specified period for delivery and non-revocation of a release spans two taxable years, payment will always be made in the second taxable year but within Section 409A’s timing requirements. All arrangements that condition payments upon the service provider’s execution of a release of claims should be reviewed to ensure compliance with these rules.

Section 162(m)

Section 162(m) generally limits the deduction that a public company may take with respect to the compensation paid to each of its chief executive officer and three other most highly compensated executive officers, other than its chief financial officer, to $1 million in any single year, unless the compensation complies with the technical “performance-based compensation” rules under Section 162(m). Typical arrangements include annual and long-term cash bonuses and performance-based equity awards. While the scope of Section 162(m) is much narrower than Section 409A, in that it only applies to the top officers of public companies, the potential loss of deduction and resulting backlash from institutional shareholders and proxy advisory firms makes the consequences every bit as significant for the companies to which it applies.

The following sets forth a few of the key Section 162(m) compliance issues that are frequently encountered in practice.

Administration of Section 162(m) Performance-Based Compensation by Outside Directors

Section 162(m) requires that the performance goals applicable to the payment of performance-based compensation must be established early in the performance period and ultimately certified prior to payment by members of the board who qualify as “outside” directors. An outside director is generally a member of the board who:

  • is neither a current employee of the company nor a former employee of the company who receives compensation for prior services other than through a tax-qualified retirement plan,
  • is neither a current nor former officer of the company, and
  • does not receive direct or indirect remuneration from the company other than in the individual’s capacity as a director.

Companies should ensure on an annual basis that each of the members of their compensation committee, or any other committee of directors that administers arrangements intended to qualify as performance-based compensation, qualify as outside directors under Section 162(m). Satisfying the independence rules under other standards, such as stock exchange rules and Section 16 of the Securities Exchange Act of 1934, is not automatically sufficient to qualify for outside director status under Section 162(m).

Shareholder Approval of Performance Goals

The payment of compensation will generally qualify as performance-based compensation under Section 162(m) only if it is payable solely on the achievement of preestablished and objective performance goals that are based on business criteria that were approved by the company’s shareholders. The shareholders do not need to approve the specific targets or metrics, just the underlying business criteria. Often, this is accomplished by adopting a compensation plan with an expansive “menu” of potential business criteria, including items such as revenue, sales, net income, and the like. The compensation committee then chooses one of the business criteria from the menu and sets specific targets.

Companies must take care to ensure that the performance measure chosen by the compensation committee is included on the list of business criteria contained in the shareholder-approved plan. It is advisable to have shareholders approve the broadest list of potential business criteria possible to ensure that the compensation committee has maximum flexibility in setting future performance goals. If the compensation committee uses a measure that is not on the shareholder-approved list, the compensation payable upon achievement of that goal will generally not qualify as performance-based compensation under Section 162(m).

Section 162(m) provides that if the compensation committee is permitted to select the actual performance targets from the menu of business criteria approved by the shareholders, then the business criteria must be disclosed to and reapproved by the company’s shareholders every five years. Companies should implement a system to ensure that this re-approval takes place before the deadline is reached.

Use of Discretion and Adjustment of Performance Goals

Performance-based compensation under Section 162(m) can only be paid upon the attainment of an objective performance goal and cannot be paid if the applicable goal is not achieved. The compensation committee cannot be permitted to pay the compensation if the goal is not achieved, and cannot use its discretion to increase the amount payable upon the achievement of the performance goal, although the compensation committee is permitted to use so-called “negative discretion” to decrease the amount that would otherwise be paid upon achievement of the goal.

Companies would often like to adjust the performance goals during the performance period to respond to changing business circumstances or to otherwise ensure that the goals continue to properly incentivize their executives. While these adjustments are often necessary or desirable from a business standpoint, the ability to make them under Section 162(m) is very limited. In general, Section 162(m) permits the adjustment of performance goals only for certain objective unforeseen events, such as a sale of a substantial division of the company, and only where the provisions for such adjustments are included at the time the goal was established.

Since the circumstances under which performance goals may be adjusted is very limited, compensation committees must be as careful as possible in setting targets that are likely to continue to appropriately incentivize executives throughout the duration of the performance period without any need for adjustment.

Payment of Compensation Upon Termination of Employment

Compensation will not qualify as performance-based under Section 162(m) if it may be paid without the achievement of the underlying performance goal upon the executive’s retirement, involuntary termination of employment without cause or a constructive voluntary termination for “good reason.” This is the case regardless of whether any of these terminations actually occur, meaning that the mere inclusion of this type of a provision in an arrangement (including an employment agreement or similar arrangement) will result in the compensation failing to qualify as performance-based under Section 162(m).

It is critical that companies structure arrangements intended to provide for performance-based compensation under Section 162(m) in a way that does not provide for payment upon any of these types of terminations without the achievement of the underlying performance goal. All applicable compensation arrangements, including employment agreements and award agreements, should be reviewed to ensure that they do not include any provisions that may result in the failure of the compensation to comply with the Section 162(m) rules.

Compliance with Annual Plan Limits

Section 162(m) requires that the shareholder-approved plan under which the compensation is payable includes annual limits on the amount of cash or number of shares that may be paid or provided to any executive subject to Section 162(m) in any single year. Compensation committees must be very careful in setting these plan limits at an appropriately high amount that is still likely to be relevant in five years, and in ensuring that the limits are not exceeded.


Section 409A and Section 162(m) contain many technical and often complicated rules that continue to challenge companies in developing and maintaining their compensation programs. It is critical to pay very close attention to these rules in creating compensation arrangements and to have specific procedures in place to ensure that the arrangements continue to be maintained in a manner that does not cause unwanted consequences and tax penalties.

By: Joseph M. Penko

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