Section 409A of the Internal Revenue Code of 1986, as amended (“Federal Section 409A”), imposes strict administrative and operational requirements on non-qualified deferred compensation arrangements, such as supplemental retirement plans, “discount” stock options and certain severance plans and agreements. Violations of Federal Section 409A can result in immediate taxation of the vested deferred compensation, interest penalties and an additional Federal tax of 20%.
California’s personal income tax law conforms to Federal Section 409A (“CA 409A”) and has historically imposed an additional 20% state tax on non-compliant deferred compensation arrangements. Under a recently passed law, Assembly Bill 1173, California reduced the CA 409A additional tax penalty from 20% to 5%. The Federal Section 409A additional penalty tax remains at 20%, for a total penalty of 25% of the value of the vested deferred compensation for California taxpayers who violate Federal Section 409A.
Notably, this reduced CA 409A tax penalty is applicable for taxable years beginning on or after January 1, 2013, so the reduced rate applies retroactively to the beginning of 2013. Even with this reduction, however, violations of Federal Section 409A and CA 409A can result in substantial penalties that can be avoided by exercising care in drafting and administering deferred compensation arrangements to avoid such violations.
Federal Section 409A and the other provisions of CA 409A are unaffected by the new law, and employers continue to have the same obligation to report Federal Section 409A and CA 409A violations and withhold ordinary income recognized under such arrangements.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.