The Full Cost of a 409A Violation
The penalties under Section 409A are deliberately punitive — Congress designed them to ensure that deferred compensation tax deferral is not abused. For employees holding options that were granted below FMV, the financial consequences can be devastating, particularly if the options have not yet vested and the employee has no liquidity to pay the tax bill.
Federal Penalties: The 20% Additional Tax
When a 409A violation is triggered (typically at vesting of options granted below FMV), the following federal tax consequences apply:
- Ordinary income tax: The full "spread" (FMV at vesting minus strike price) is included in the employee's gross income in the year of vesting. For a Silicon Valley engineer in the highest bracket, this means approximately 37% federal income tax.
- 20% additional tax: An additional 20% additional federal tax under §409A applies to the amount of deferred compensation that is included in income. This is on top of, not instead of, ordinary income tax.
- Interest: Underpayment interest at the IRS federal short-term rate plus 1% applies from the later of the vesting date or the first year the compensation was no longer subject to substantial risk of forfeiture.
Combined, an employee can face a substantially elevated effective marginal rate on the option spread once the options vest.
State-Level Penalties
State treatment varies. California is the main state imposing its own §409A additional tax; most others tax the income inclusion at ordinary rates only:
- California: 5% state additional tax on top of the 20% federal additional tax (reduced from 20% by AB 1173, effective for taxable years beginning on or after 1 January 2013), giving a 25% combined additional tax before ordinary income tax and premium interest
- New York: Conforms to federal §409A treatment; no additional state penalty but high income tax rates
- New Jersey: State income tax on the spread but no separate additional tax
Company-Level Consequences
The company also faces consequences when a 409A violation occurs:
- Withholding failures: The company is required to withhold income tax and employment taxes on the spread at vesting. If it fails to do so, it faces penalties under IRC §6672 (Trust Fund Recovery Penalty) and interest.
- W-2 reporting errors: Failed withholding may require amended W-2s for prior years, triggering additional penalties
- D&O liability: Officers who were aware of the violation may face claims from employees harmed by the tax consequences
- Investor scrutiny: Discovered in M&A due diligence, unresolved 409A violations can delay or reduce deal value
IRS Correction Programs
In limited circumstances, 409A violations can be corrected under IRS Notice 2008-113. Corrections are only available for:
- Operational failures (not document failures)
- Corrections made in the same year as the failure, or within two years for certain inadvertent errors
Corrections are complex, require legal counsel, and are not always available. Prevention — through timely, qualified 409A valuations — is far less costly than correction.
Sources
- 26 U.S.C. §409A — Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans
- Treas. Reg. §1.409A-1(b)(5) — Stock rights, including the valuation safe harbours
- IRS Notice 2008-113 — correction of operational failures under §409A
- IRS Notice 2010-6 — correction of documentary failures under §409A
General information, not tax advice. Section 409A outcomes turn on specific facts — consult a qualified tax adviser.