The IRS has changed the rules governing deferred compensation. Internal Revenue Code (IRC) Section 409A sets more stringent guidelines for private companies when issuing stock options and other forms of non-qualified deferred compensation. Deferred compensation is compensation that promises the benefit in one year and pays the benefit in another year.
Section 409A was added to the IRC by section 885 of the American Jobs Creation Act of 2004. Section 409A generally provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income.

For companies that issue stock options with a strike price less than the fair market value of the underlying stock, employees who receive the stock options can be subjected to additional tax, interest, and penalties. It is important for companies to obtain a qualified independent fair market value appraisal when issuing stock options.

The deadline for compliance was December 31, 2008. If a plan fails to comply with Section 409A, compensation deferred under the plan for that taxable year and all preceding taxable years is immediately includible in taxable income. In addition, the amount included in income is subject to a 20% excise tax plus an interest penalty. The taxes and penalties are imposed on each participant who is affected by the company’s failure to comply.

Section 409A does not apply to certain types of plans, such as qualified retirement plans, certain severance plans, and stock options that do not provide for deferral of compensation.