Section 409A of the US Internal Revenue Code (IRC 409A) controls nonqualified deferred compensation paid by a service recipient to a service provider. The recipient is generally employers or those hiring independent contractors. A service provider includes staffed employees, independent contractors, and executives. IRC 409A generally imposes a 20% excise tax on compensation paid to these service providers when operational rules in the code have been violated.

While IRC 409A theoretically doesn’t apply to employees from another country, it does contain provisions that can ensnare employers of those working outside the United States. If you hire independent contractors outside the United States, you’ll want to be aware of these potential issues and how to avoid them.

Avoiding Section 409A Pitfalls for Foreign Deferred Compensation Arrangements

The guidelines surrounding this code are complex, so it’s advisable to work with an attorney when deferred compensation for foreign employees is involved. Legal expertise can help you avoid these common pitfalls.

Pitfall #1: Deferred Compensation for a Foreign Worker who Becomes a US Resident

Deferred compensation is usually subject to Section 409A if a Nonresident Alien (NRA) outside the US earns compensation for work performed abroad and then becomes a US resident before receiving the payment. This is referred to as “imported deferred compensation.”

If the NRA becomes a US resident at any point after receiving compensation, an exemption from Section 409A would usually apply. However, deferred compensation only qualifies for an exemption if:

• It would not have been subject to US taxes at the time of payment
• The contractor or employee was still an NRA after receiving compensation

The exemption fails to cover imported deferred compensation not yet received when the NRA attains US residency.

Pitfall #2: Foreign Earned Income Deferrals for Plan Participants Who Are Exported

Section 409A usually covers US citizens who commence work abroad and gain coverage under non-US deferred compensation agreements. However, there are exemptions in the 409A regulations.

IRC 911, which applies to American citizens overseas when certain conditions are met, has an exclusion limit of $108,700 for the tax year 2021.

Funded retirement plans are one exclusion under Section 409A where a US taxpayer does not have to pay tax on any sum contributed to a funded foreign retirement plan. This is known as a “funded arrangement.” However, the individual will be required to pay regular income tax on that amount at the time of vesting.

Broad-based foreign retirement plans are another exemption, occurring when a US resident transfers to work outside the US and participates in a foreign plan of deferred compensation. The exemption applies when the worker is ineligible for the US retirement plan. If the deferral per annum is not over IRC 415 limits, a deferral is not an option and is linked to income earned abroad.

If an American citizen working outside the US has an entitlement to tax equalization payment for the reimbursement of additional tax costs in two countries, they may be exempt from 409A regulations.

Facing an IRC 409A Penalty? We Can Help

If your business is facing an IRC 409A tax penalty involving foreign contractors or workers, the experienced attorneys at Rooney Nimmo, including Partner Timothy M. Davis, can help you find a solution. We are corporate lawyers who know exactly how the US tax code works and how it is used against entrepreneurs and businesses who may not know how to defend themselves. If you are facing a fine from the IRS, contact Rooney Nimmo today for a consultation.