3556 / Does Section 409A apply to independent contractors?

IRC Section 409A generally does not apply to amounts deferred under an arrangement between an employer and either an accrual-based independent contractor or an unrelated independent contractor. If both the employer and the independent contractor are accrual-based taxpayers, the agreement is not a nonqualified deferred compensation plan covered by Section 409A. However, the IRS has clarified that a “service recipient” may be an entity and not just a natural person.¹

In addition, if, during a contractor’s taxable year in which an amount is deferred, the contractor provides significant services to each of two or more service recipients that are unrelated, both to each other and to the independent contractor, the arrangement does not involve a deferral of compensation under Section 409A; the plan is not covered by Section 409A. For this exception, a safe harbor rule provides that an independent contractor will be treated as providing significant services to more than one service recipient where not more than 70 percent of the total revenue of the trade or business is derived from any particular service recipient or group of related service recipients. Unfortunately, there is no three-of-five or similar multiyear feature in this safe harbor rule.²

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Practice Point: The IRS has clarified that when an employee changes status to an independent contractor the former employee will be treated as having separated from service for purposes of 409A if at the time of separation the level of services to be reasonably expected would result in a separation of services under the employee rules (generally less than 20-50 percent of the prior level of services).³

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