How Does a 409A Plan Work

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Workers commonly will get paid for compensation at some time in the future. In determining how much money the workers will get, it will refer to a 409 Plan. The section 409A definitely covers most nonqualified deferred compensation arrangements.

To give a sum of money to workers, the company commonly takes a nonqualified deferred compensation plan where the company promises to pay its participants in a subsequent plan year. Then, how does a 409A plan work in giving the compensation? Let’s see more information about it in our post below!

How Does a 409A Plan Work

How Does a 409A Plan Work?

Basically, a 409A sets a ‘strike price’, meaning the price that the workers can buy equity in the company. The ‘strike price’ here should be set at or above fair market value.

Unless a specific exception applies, and imposes election, specific timing and distribution requirements on covered arrangements that basically prevent taxpayers from being able to manipulate the timing of tax recognition in their favor, the section 409A definitely covers most nonqualified deferred compensation arrangements.

In this case, deferrals are includible in income at vesting and subject to a 20% additional tax if a nonqualified deferred compensation (NQDC) plan fails to comply with the requirement of section 409A.

In some situations, an underpayment interest penalty may also apply, as a nonqualified deferred compensation arrangement subject to section 409A that is defined as any plan, including any agreement or arrangement. The arrangement and agreement also provide for the deferral compensation other than a qualified employer plan and any bona fide vacation leave, compensation time, sick leave, death benefit plan or disability pay.

This nonqualified deferred compensation is actually different from deferred compensation which comes from qualified plans like 401(k) plans, 457(b) plans and 403(b) plans.

Certainly, there are laws that you need to follow when preparing a NQDC plan with your employees. The section 409s available on IRS describes the rules for nonqualified deferred compensation plans.  To defer your employee’s income until a later date, the company cannot just have a verbal agreement with your employees.

A plan that provides for deferred compensation is one under that takes into account the facts and circumstances of the arrangement. In this case, the service provider has a binding right in one year to compensation legally which is or may be payable in a later taxable year. The short-term deferrals, certain foreign plans, certain separation pay plans and many welfare benefit plans are exempted from the definition.

How to Set a 409A Plan?

There are some stages that you may pass through in setting up a 409A plan. Here are they:

1) Put the plan in writing

First thing first, you need to think of it as a contract with your employee. Make sure to include the deferred amount and when your company will pay it.

2) Decide on the timing

You may also need to choose the events which trigger when your company will pay an employee’s deferred income. Here are some events:

  • Retirement
  • Death
  • Termination
  • A fixed date
  • Change in business ownership
  • Unforeseeable emergency

3) Note requirements or exclusions of the plan

Of course, you should note any qualifiers your employee needs to follow to receive their pay. For instance, your NQDC plan probably reveals that your employee cannot work at a competing business after retiring.

Why Is the 409A Plan Important?

The reason why a 409A plan is actually important, particularly for startups, is to get recognition from the IRS about the value that your private stock holds. If you do not price it properly and fairly, the IRS may perceive it as giving away something of value without factoring the tax implications.

In fact, most startups are not subject to a 409A IRS audit. Certainly, there is greater potential for an IRS audit when your company starts to become profitable. Aside from audit, the Securities and Exchange Commission may check your pre-IPO stock awards.

Both of those processes are actually expensive and time-consuming. Of course, a 409A Valuation will be needed to prevent these types of problems and also decrease the potential for lawsuits.

What Are the Advantages of a 409A Plan?

Nonqualified deferred compensation plans actually benefit both your company and your employees.

If you are an employer, a NQDC plan will give you some following benefits:

  • Flexibility: You will be able to select which executive or highly compensated employees can participate. You should offer this plan to every employee, since there are not any non-discriminatory rules.
  • Small management fees: To set up a NQDC plan, there will be small upfront costs. However, you will not need to deal with ongoing fees to manage it.
  • Cash flow increases: The money that your company brings in can be used for other things, as it does not need to go towards paying your employee right away.

If you are an employee, a NQDC will benefit you, including:

  • No maximum contribution amount: the IRS actually puts a limit to how much an employee can contribute to their 401(k) each year. There is no limit with the NQDC plan.
  • Tax advantages: They will have less taxable income that can put them in a lower tax bracket, when your employee makes their deferral election.

What Are the Disadvantages of a 409A Plan?

In addition to benefiting both your company and your employees, a 409A plan or NQDC plan also has some disadvantages. Here they are:

  • Withdrawing funds: Your employee will only be able to withdraw funds from a nonqualified deferred compensation plan on a predetermined date. They definitely cannot withdraw early like they can with a 401(k) or other qualified retirement plans.
  • Fund protection: Your employee’s money is not protected by the Employee Retirement Income Security ACT (ERISA). It totally becomes a part of your business’ assets when they defer their income. It definitely could affect their retirement if you need to use money.

The point is, employee benefits are an important part of compensation packages. So, a nonqualified deferred compensation (NQDC) plan actually provides extra tax-deferred savings options to a small group of top individuals within your company.

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