Common Clauses

What does the Section 409A clause mean?

Mar 19, 2024

The Section 409A clause is common in employment, equity, and separation agreements that reference deferred compensation, such as equity, long-term executive bonuses, and severance payments. This week, we cover the basics of what it means and why that clause is there. However, we do have to include a disclaimer that tax codes are extremely complicated and this week’s post just scratches the surface!

What is the Section 409A clause?

In the simplest terms, this clause is saying “the deferred compensation you are receiving complies with the law”.

The law is referring to Section 409A of the U.S. Internal Revenue Code, which regulates how deferred compensation gets taxed. It was originally intended to curb excessive executive deferred compensation trying to evade taxes, but applies to much broader compensation types today.

Typically, the clause is a lengthy paragraph that includes something along the lines of: “Equity granted pursuant to this Agreement complies with or is exempt from Code Section 409A.” Let’s break down the components of this clause:

  1. Deferred Compensation: Compensation that is earned currently but received in some future date. Equity and severance payments are both examples of deferred compensation.

  2. 409A: This tax law determines whether or not deferred compensation is ‘nonqualified’. ‘Nonqualified’ deferred compensation is immediately taxable and could involve significant tax penalties (20% plus interest!)

  3. Exemptions: 409A calls out specific types of compensation that are exempt from its rules, such as ISO options, Restricted Stock Awards (RSAs), and qualified ESPPs. Nonqualified options can also be exempt if they meet certain requirements.

Putting it all back together, the 409A clause acknowledges that you are receiving deferred compensation, that such compensation has specific tax requirements, and that they’ve followed all the rules to ensure it’s exempt from nonqualified tax penalties.

Why is the 409A clause in your agreement?

As all laws are in effect regardless of whether they’re referenced in contracts, a 409A clause doesn't have to be in your contract. We see the clause about 50% of the time, ranging from 1~2 sentences to half a page. However, when they are included, they are intended to confirm the following:

  1. All deferred compensation is intended to be exempt from adverse tax consequences of 409A.

  2. Here are the specific requirements to be followed to ensure compliance of 409A.

  3. If for some reason, the payments are found to be ‘nonqualified’, [you/the employer] is responsible for tax penalties.

You’ll want to keep an eye out on (3) in particular, as there are cases where employees are responsible for tax penalties even when the noncompliance may have been due to the action of their employer. Ultimately, the IRS attributes deferred compensation tax penalties to the individual, not the employer.

For most employees, the Section 409A clause may seem like a FYI clause with nothing to negotiate. While that may be true, we still believe it’s important to understand what you’re agreeing to and ask the right questions to trust that your company knows what they’re doing. After all, your bill for a poorly run deferred compensation program is immediate income tax, a 20% penalty tax, and interest.

For advocacy and beyond,
The Ask Ginkgo Team

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