IRS Section 409A Compliance: What Employers Must Know To Protect Employees From Tax Penalties

What is Section 409A?

Section 409A is a federal tax rule issued by the IRS that regulates how and when private companies must report and value Non-Qualified Deferred Compensation (NQDC) arrangements. 

What is Non-Qualified Deferred Compensation (NQDC)?

Deferred compensation refers to any arrangement where you earn income now but receive it in a future year.

Non-Qualified Deferred Compensation (NQDC) is a subset of this. It includes compensation that is not part of a tax-qualified retirement plan. 

For example, arrangements like deferred bonuses, RSUs, phantom stock, Stock Appreciation Rights (SARs), and discounted Non-qualified Stock Options (NSOs).

Section 409A imposes strict rules on timing, documentation, and valuation to prevent Non-Qualified Deferred Compensation (NQDC) from being unfairly structured to delay taxation (more on this later in the post).

This section applies to both the service provider (such as employees, contractors, advisors, and board members) and the service recipient (typically the employer or company). Any non-qualified deferred compensation arrangement that defers compensation must meet 409A rules, and both parties bear responsibility.

Exclusions to Section 409A

Equity or compensation that is either taxed immediately, governed by other IRS regulations, or structured without any deferral risk is excluded from Section 409A compliance.

It includes:

• Incentive Stock Options (ISOs)
• Qualified Employee Stock Purchase Plans (ESPPs)
• Restricted Stock Awards (but not RSUs)
  

Additionally, Non-qualified Stock Options (NSOs) are generally exempt if they meet all of the following conditions:

• They are issued over service recipient stock (common stock of the company you're working for, or its parent)
• The strike price is equal to or above the fair market value (FMV) on the grant date
• The option is taxed under IRC Section 83 (i.e., taxable at exercise)
• There is no additional deferral feature beyond the grant-to-exercise window.

Consequences of Section 409A non-compliance and why employers need to be aware

If a non-qualified deferred compensation arrangement fails to comply with Section 409A, the tax consequences fall directly on the employee. 

• In case of a violation, all deferred amounts under that plan (and potentially under similar plans that must be aggregated) become immediately taxable once vested. 
• Additionally, the affected employee is subject to a 20% federal penalty tax on the income and may owe additional interest for underpaying taxes.

For example, Marvell Technology’s CEO, Sehat Sutardja, received stock options that were priced in December 2003 but not formally approved until January 2004, by which time the stock price had increased. The IRS determined the options were granted below FMV and violated Section 409A. Sutardja challenged the tax but lost and paid over $5 million in penalties.

Although the excise tax applies to the employee, employers are not off the hook

Once non-compliance is identified, your company should report the income in Box 12 of the W-2 (using code Z) and withhold applicable income taxes on the compensation. Failure to do so can trigger additional IRS penalties for the employer.

Beyond tax exposure, non-compliance signals poor internal governance and can damage your company’s credibility. It raises red flags for investors and prospective hires who expect clean, audit-proof compensation practices.  

Companies should get a 409A valuation when issuing stock options

If your company grants stock options or SARs, you must prove the strike price equals FMV on the grant date. Otherwise, the grant may be treated as deferred compensation under Section 409A, which could trigger tax penalties for your team.

To avoid this, private companies should get a 409A valuation from a qualified, independent provider. More than a legal box to tick, it protects employees from IRS scrutiny and prevents option grants from becoming tax liabilities.

Most startups need a new valuation every 12 months or after a material event like fundraising. If you are unsure whether a certain event is material, please reach out to us. 

Section 409A: Key compliance rules

To comply with Section 409A, employers must follow specific requirements governing deferral elections, permissible payment events, the timing of distributions, and plan definitions. 

1. Initial deferral elections must be timely and irrevocable

Deferral elections must generally be made before the start of the calendar year in which the compensation is earned. This means that if an employee wants to postpone payment, for example, deferring a bonus or equity payout, they must formally elect to do so in advance. The elections must also specify the timing and payment method, and are irrevocable once made.

For performance-based compensation, elections can be made no later than six months before the performance period ends, provided that:

• The performance period is at least 12 months long
• The employee continuously provides services during the period 
• The compensation is not readily determined at the time of the election.

2. Subsequent deferral changes require strict timing

Employers can permit changes to deferral elections only if:

• The change is made at least 12 months before the scheduled payment
• The payment is delayed by at least five years from the originally scheduled payment date

Note: The new election will not take effect for at least 12 months.

3. Payments are limited to six permissible events

Deferred compensation can only be paid upon:

• Separation from service
• Disability
• Death
• A fixed date or schedule specified at the deferral
• Change in control
• Unforeseeable emergency

4. Acceleration of payment is prohibited

Section 409A prohibits discretionary acceleration of payments by the employee or the company (except in very limited, IRS-permitted exceptions). 

Even plan termination does not automatically allow acceleration because of strict limitations.

5. Short-term deferral exception

Compensation paid within 2.5 months after the end of the year (i.e, March 15) in which it vests may be exempt from 409A as a short-term deferral. 

But if the plan permits deferral beyond this window (even if it doesn’t actually occur), it won't qualify for the exemption.

6. Severance pay and exceptions

Severance payments are subject to Section 409A unless they qualify for an exemption. For example, an involuntary severance pay is exempt, provided that it:

• Does not exceed the lesser of two times the employee’s prior-year compensation or two times the qualified plan compensation cap.
• Is paid within two years following separation.
  

Note: Terminations with “Good reason” may qualify as involuntary separation, but must meet specific rules established by the IRS.

7. Plan aggregation rules

All non-qualified deferred compensation (NQDC) plans of the same type that cover a single participant are treated as one plan. There are nine categories of NQDC plans (e.g., salary deferral plans, bonus deferral plans).

A violation in one plan affects all others in the same category, and the tax penalties apply to the aggregate amount.

8. Six-month delay for public company executives

Key employees at publicly traded companies must wait at least six months after separation from service to start receiving deferred compensation. 

This particular rule applies to 'specified employees' (a category that involves certain highly compensated officers and key shareholders) as defined by the IRS. 

Common Section 409A pitfalls to avoid

Many compliance issues under Section 409A are mostly because of administrative oversights rather than intentional violations. Employers should watch for these recurring errors:

• Improper timing of elections: Deferral and distribution elections must be made before compensation is earned. Late elections are not valid.
• Non-compliant definitions: Key terms must follow Section 409A’s definitions, not common usage. An example is using definitions for “separation from service,” “disability,” or other terms that don’t match Section 409A’s strict criteria. 
• Mistimed payments: Paying deferred compensation too early or too late (outside the permitted event or schedule) triggers penalties.
• Incorrect deferral calculations: Misapplying deferral amounts or failing to track vesting correctly creates exposure to a penalty.

Correction programs and mitigation strategies

The IRS permits correction of certain operational failures under Section 409A through the process outlined in Notice 2008-113. 

To avoid full taxation and penalties, employers must act within a strict timeframe: For many errors, this means fixing the issue by the end of the second calendar year following the year of the failure. After that, the affected amounts become fully taxable, and the additional 20% excise tax applies.

The correction methods under this notice are detailed and highly specific to the type of failure, such as missed deferral elections, incorrect payment timing, or overpayments. 

Corrections may require the participant to:

• Repay amounts (e.g., overpaid compensation)
• Forgo earnings on underpaid amounts
• Pay additional taxes, or
• File amended tax returns for prior years.

In addition to participant action, employers have reporting obligations. 

Corrections must be disclosed on the employer’s federal tax return for the year of correction. If the correction isn’t made in the same year as the failure, the employee must attach a correction statement to their tax return for the year of the failure. The employer must give this statement to the employee by January 31 so it can be filed with the prior-year return

Tip: Begin the correction process early. Rushed end-of-year communications about missed deferrals or repayments often create unnecessary friction. Align payroll, legal, and tax teams well in advance of deadlines to avoid further non-compliance.

To help you reduce risk and avoid costly penalties, we’ve created a practical Section 409A Compliance Checklist. 

FAQs on Section 409A compliance

1. Does Section 409A apply to contractors or advisors, or just employees?

Yes. Section 409A applies to all service providers (including contractors, advisors, and board members) if they receive non-qualified deferred compensation. It’s not limited to W-2 employees.

2. How often does a private company need a 409A valuation?

At least once every 12 months or sooner if there’s a material event such as a fundraising round, secondary sale, or acquisition.

3. How do we handle 409A compliance across multiple compensation plans?

Plans of the same type (e.g., salary deferrals, bonuses, SARs, discounted NSOs) are treated as a single plan. A compliance failure in one can affect all others. It’s important to have a dedicated team/authority to review compliance regularly.

4. Is Section 409A compliance reviewed during due diligence?

Yes. Investors, acquirers, and auditors often scrutinize deferred compensation plans and 409A valuations during fundraising and M&A. Non-compliance can delay deals or reduce company valuation.