This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.
If deferred compensation meets the requirements of Section 409A, then there is no effect on the employee’s taxes. The compensation is taxed in the same manner as it would be taxed if it were not covered by Section 409A. If the arrangement does not meet the requirements of Section 409A, the compensation is subject to certain additional taxes, including a 20% additional income tax. Section 409A has no effect on FICA (Social Security and Medicare) tax.
Silicon Valley startups often target having their 409a valuation come in around 1/5th the price of the most recently sold Preferred Stock.
Section 409a was added to the Internal Revenue Code, effective January 1, 2005 under section 885 of the American Jobs Creation Act of 2004. The broad definition of deferral of compensation means the effects of Section 409a are far-reaching. Section 409a was enacted, in part, in response to the practice of Enron executives accelerating payments under their deferred compensation plans in order to access money before the company went bankrupt, and in part in response to perceived tax-timing abuse due to enforcement of the constructive receipt tax doctrine.
Section 409a's timing restrictions fall into three main categories: restrictions on the timing of distributions, restrictions against the acceleration of benefits, and restrictions on the timing of deferral elections.
Distributions under a non-qualified deferred compensation plan can only be payable upon one of six circumstances: the employee's separation from service, the employee's becoming disabled, the employee's death, a fixed time or schedule specified under the plan, a change in ownership or effective control of the corporation or a change in the ownership of a substantial portion of the assets of a corporation, and the occurrence of an unforeseeable emergency.
Section 409a assigns compliance-failure penalties to the recipient of deferred compensation and not to the company offering the compensation. The penalties written into law are: all compensation deferred for the taxable year and all preceding taxable years become included in gross income for the taxable year to the extent the compensation is not subject to a substantial risk of forfeiture and has not previously been included in gross income; accrued interest on the taxable amount; and an additional penalty of 20% of the deferred compensation which is required to be included in gross income.
Title 26 - Internal Revenue Code 409a