No ERISA, no problem? Common Section 409A compliance pitfalls for nonqualified deferred compensation arrangements

Reprinted with permission from the July 21, 2026, edition of The Legal Intelligencer© 2026 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Employers often view nonqualified deferred compensation (NQDC) plans as relatively free of regulatory complexity because ERISA’s most demanding requirements, such as funding, vesting schedules, fiduciary duties, and plan termination insurance, generally do not apply. That assumption can breed complacency.

Section 409A of the Internal Revenue Code fills much of the gap ERISA leaves open on NQDC plans, imposing detailed rules on the structure, documentation, and payment of deferred compensation. Violations carry severe consequences for participants, including immediate income inclusion, a 20% additional tax, and an interest-based penalty, with employers facing their own withholding, reporting, and employee-relations exposure.

Section 409A of the Internal Revenue Code is a hidden compliance risk that imposes its own rules on structuring and administering NQDCs. Employers should ensure their NQDC plans and employment, bonus, incentive, and severance arrangements, which may be considered NQDC plans, are aligned with Section 409A’s requirements, if applicable.

Key takeaways:

• Mind the short-term deferral deadline. To avoid Section 409A coverage, compensation must generally be paid by March 15 of the year following vesting.
• Specify time and form of payment up front. The payment trigger and form must be established at the time of the deferral election, not left to later discretion.
• Structure severance carefully. Severance may qualify for a statutory exception, but if it does not, the arrangement must comply with Section 409A.
• Watch release-of-claims timing. When severance is conditioned on the employee signing a release, draft the payment provision so the employee cannot control the taxable year of payment.
• Understand the penalty regime. Non-compliance triggers income inclusion, a 20% additional tax, and interest penalties for the participant, with indirect consequences for the employer.

NQDC plans

NQDC plans generally include any plan, agreement, program, or arrangement that provides for deferred compensation and is not a tax-qualified retirement plan. Unlike qualified plans such as 401(k)s, NQDC plans generally are not subject to statutory contribution limits or the same nondiscrimination requirements. They are not required to be held in a protected trust.

Timing of payment: Short-term deferral rule

Compensation is typically “deferred” if it is paid later than 2.5 months after the end of the taxable year in which the compensation is vested, or no longer subject to a substantial risk of forfeiture. In other words, if the compensation is not subject to a substantial risk of forfeiture, it must be paid within 2.5 months of the taxable year in which it vested to avoid 409A obligations. For employers whose arrangements rely on the calendar year, the deadline is March 15 of the year following the year in which the compensation vests. For example, an annual bonus earned in 2026 must generally be paid by March 15, 2027, to remain within the short-term deferral exception.

This short-term deferral rule is especially important for annual bonuses, transaction bonuses, long-term incentive awards, and severance arrangements that are intended to fall outside Section 409A. If payment is made after the short-term deferral deadline, the arrangement is not automatically in violation of Section 409A of the Internal Revenue Code. Still, it may need to comply with Section 409A unless another exception applies. Section 409A restricts both the employee’s and the employer’s ability to control the timing and form of payment after the relevant deferral election has been made.

Required level of specificity

Section 409A requires NQDC plans to specify both the time and form of payment at the time of the relevant deferral election. Deferred compensation may not be distributed earlier than one of the permissible payment events, which are:

• Separation from service
• Disability
• Death
• Time specified under the plan, or pursuant to a fixed schedule, set at the date of deferral
• Qualified change in control
• Unforeseeable emergency

Further, the plan must provide that deferred compensation may be paid solely upon one of these permitted events or times. Otherwise, the plan must designate the payment date, year, or schedule with sufficient objective specificity. The plan may provide a payment schedule, including a schedule over multiple taxable years, but the schedule must be objectively determinable and nondiscretionary at the time of the triggering event. If the plan provides for payment during a designated payment period, the period generally must either begin and end within one taxable year or be no more than 90 days after the triggering event. Additionally, the participant generally should not be able to choose the taxable year in which payment is made.

The plan must also specify the form of payment, generally lump sum or installments, at the time of the deferral. Open-ended language permitting payment “as soon as practicable,” “at the employer’s discretion,” or “as elected by the employee” can create Section 409A risk if it allows either party to control the year or form of payment after the deferral election has become fixed.

Severance payments

When employment arrangements such as employment agreements and separation agreements involve deferred severance payments, Section 409A may be implicated. Section 409A includes an exception for certain severance payments made only on account of involuntary terminations. That exception applies where the payments do not exceed a certain amount and are paid within two years from the year that the separation occurs. If this exception, the short-term deferral exception, or another exception is not met, then the severance arrangement must comply with Section 409A.

Employers should also be careful when conditioning severance payments on a release of claims. A release condition is common and generally permissible. Still, the payment provision should be drafted so that the employee cannot control the taxable year of payment by choosing when to sign the release. For example, if the release period may straddle two calendar years, the employer may consider including in the agreement that payment will be made in the later year.

Risk of non-compliance

If an NQDC plan fails to satisfy Section 409A, the compensation deferred under the plan not subject to a substantial risk of forfeiture is includible in gross income for that taxable year, to the extent it has not already been included in income. Further, Section 409A increases the participant’s tax liability by 20% of the deferred compensation required to be included in income. Finally, Section 409A imposes an interest-based penalty on the deferred amount. While the tax consequences are imposed on the participant, the employer may have withholding, reporting, and employee-relations consequences.

For these reasons, employers should take special care to examine their deferred compensation arrangements, including bonus plans, long-term incentive plans, employment agreements, and severance payments, to determine their applicability and compliance with Section 409A.