How Does Section 409A Affect Incentive Compensation by LLCs Taxed as Partnerships?

Welcome to the newest installment in our series on incentive compensation for partnership-taxed LLCs. In this edition, we will delve into Section 409A of the Internal Revenue Code and explore its various implications for incentive compensation planning. Join us as we unravel the subtle distinctions between the diverse effects for rewards offered by LLCs taxed as partnerships.

Compliance with Section 409A

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation plans and aims to prevent companies from using such plans to get inappropriate tax advantages. The fundamental rules under this provision include:

1. Initial Deferral Elections: Subject to various exceptions, participants must make an initial deferral election before the beginning of the year in which they are to perform the services related to the deferred compensation. This election should specify the amount of compensation to be deferred and the conditions under which it will be paid out.
2. Permissible Distribution Events: Distributions from a deferred compensation plan can only occur during specific events such as separation from service, disability, death, a predetermined date or schedule, or an unforeseeable emergency. Issues concerning severance and separation pay are beyond the scope of this article.
3. No Acceleration of Payments: The company (or LLC) is not allowed to accelerate the payment of deferred compensation. This rule helps ensure that the plan does not serve as a vehicle for tax avoidance.
4. Subsequent Deferral Elections: If participants wish to make subsequent deferral elections, they must follow specific guidelines. The new payment date must be at least five years later than the original payment date, and the election must be made at least 12 months before the original payment date. Additionally, subsequent deferral elections cannot take effect until at least 12 months after the date on which the election is made.

The Impact on Different Incentive Compensation Plans

Noncompliance with the provisions of Section 409A can lead to substantial tax penalties and additional taxes for both the team member and the partnership-taxed LLC. However, not all forms of incentive compensation fall under Section 409A.

For example, capital interests are not viewed as deferred compensation, and thus, they are not subject to these tax regulations. When it comes to options on capital interests, the exercise price is the determining factor in whether they fall under these complex rules. If the exercise price is equal to or greater than the Fair Market Value (FMV) at the time of the grant, the reward is exempt from Section 409A. However, if the exercise price is below the FMV, it becomes subject to these regulations. Consequently, most companies set the exercise price equal to the FMV to steer clear of the intricate laws pertaining to 409A.

Phantom equity and other cash incentives, on the other hand, are deemed deferred compensation and are subject to Section 409A and the complex legal nuances associated with it. Therefore, partnership-taxed LLCs must ensure that they issue these incentives in accordance with Section 409A regulations to avoid possible tax consequences for both the team member and the partnership-taxed LLC.

The Short-Term Deferral Exception

The short-term deferral exception serves as an exemption to Section 409A. To qualify for this exception, a deferred reward must be paid within 2.5 months after the end of the tax year in which the team member’s right to the reward is no longer subject to a “substantial risk of forfeiture.” For instance, if a team member’s reward depends on finishing a project by December 31, 2024, the payment should be made no later than March 15, 2025, provided the company’s tax year concludes on December 31, 2024. By fulfilling these requirements, the payment is exempt from Section 409A and its intricate regulations.

Looking forward

We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.

Join us tomorrow for an engaging discussion on how securities laws impact incentive compensation plans for partnership taxed LLCs. Don’t miss out on this informative topic - stay tuned and catch up with us then!

This article is for informational purposes only and should not be relied upon as tax advice. Please consult your tax professional for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.