SECTION 409A: Pitfalls for the Unwary and June, 2016 Proposed Regulations
Wide Application of Code Section 409A.
As may you know, Section 409A of the Code governs the design and taxation of “non-qualified deferred compensation.” IRS regulations defines that term in a very broad manner, and it includes (among other items) the following –
i. Severance Benefits under Employment Contracts and Separation Agreements;
ii. Annual Bonuses;
iii. Long-Term Cash Incentive Plans;
iv. Stock Options and Stock Appreciation Rights;
v. Restricted Stock Units;
vi. Success Fees, Change in Control Agreements and Stay Bonuses related to M&A Transactions;
vii. Non-Compete Agreements;
viii. Window Early Retirement Programs;
ix. Consulting Agreements;
x. Sabbatical Programs;
xi. Expense Reimbursements;
xii. Certain Health and Welfare Benefits
xiii. Phantom Stock; and, of course
xiv. Traditional Deferred Compensation Programs (including, but not limited to, SERPs, Excess Benefit Plans and Elective and Non-Elective Compensation Deferral Plans).
Improper drafting and administration of “non-qualified deferred compensation” programs will result in severe penalties being imposed on the person receiving the deferred compensation. First, the individual will be subject to tax on the entire amount of the deferred compensation at the time the violation (either in drafting or in operation) occurs, even if payment of the amounts will not be made until years in the future. The individual also will be subject to a 20% penalty tax and certain interest charges. The employer providing the deferred compensation is required to withhold on and report Code Section 409A violations and may be subject to penalties for failures to do so.
If you are an attorney representing an executive in negotiating an employment contract or other compensation plan and the rules of Code Section 409A are not followed, you may face a malpractice suit for the ensuing losses. Similarly, you may face litigation if you are representing the employer because executives may commence actions against their companies for failures to adhere to Code Section 409A, and these companies undoubtedly will look to pass their liabilities on to the firm advising on and/or drafting the program.
Because (i) the definition of non-qualified deferred compensation is so broad, (ii) the penalties for failing to comply with the requirements of Code Section 409A are so onerous, (iii) your potential liability for failing to draft a contract or agreement in compliance with Code Section 409A is substantial, (iv) the Section 409A rules are so complicated and convoluted and (v) the IRS is aggressively auditing Code Section 409A programs, it is important to have all of your current and future arrangements reviewed to determine whether Code Section 409A applies and, if it does, to make sure that its requirements are fully satisfied.
Code Section 409A Pitfalls to Avoid.
Most often the payment of severance payments to an employee are subject to the employee’s signing, and not revoking, a waiver and release of claims against the employer. However, many severance agreements, either standing alone or included in an employment contract, do not provide for a deadline for the employee to sign the release and, accordingly, also do not provide for a specific date on which the severance benefits will be paid or commence. This lack of specificity is a violation of Code Section 409A. It is permissible for a severance agreement to provide that payment of severance benefits will commence or be made within a specified period (not to exceed 90 days) after separation from service. However, if the specified period spans two taxable years, the payment must be made, or commence, in the second taxable year.
Under Code Section 409A, payments of non-qualified deferred compensation are permitted only upon certain dates or events. Many deferred compensation plans subject to Code Section 409A provide for payments to be made upon a company’s IPO. However, in most cases an IPO is not one of the permitted payment events.
Code Section 409A imposes a six-month delay for employment termination payments made to certain executives of public companies. This requirement has been overlooked by more than a few companies.
Often deferred compensation plans provide that payments to be made upon an individual’s termination of employment will be offset by certain other benefits not intended to subject to Code Section 409A. IRS regulations generally provide that offsets like these will constitute a violation of Section Code 409A.
In many cases, the terms of executives’ severance benefits are renegotiated at the time the executives are terminated. These “substitution payments” may violate Code Section 409A unless carefully structured.
Many practitioners believe that payments under an arrangement subject to the provisions of Code Section 409A can be made upon termination of employment. However, the IRS regulations state that the payments can be made only upon a “separation from service” and further provide that a separation from service will not be deemed to have occurred if a certain level of service (such as post-employment consulting services) is provided after employment termination. Thus, it is very important that post-employment arrangements with former employees be carefully reviewed in order to avoid violating the separation from service rule.
Generally, an election to defer a bonus must be made prior to the year in which the services related to the bonus are performed. However, there have been many instances where these elections are made at the end of the performance year. These delayed deferral elections will violate Code Section 409A
One type of payment that is not subject to the provisions of Code Section 409A is a “short-term deferral” (i.e., a payment made within 2 ½ months after the end of the year during which the employee became vested in the payment). IRS regulations require that the terms of the agreement under which a short-term deferral is made must specifically provide that under all circumstances the payment will be made within the short-term deferral period. This drafting requirement is often overlooked. It is important to note that for these purposes, a payment that is conditioned upon involuntary termination or termination for “good reason” will not be considered to vest until the termination occurs. However, IRS regulations set forth detailed rules as to how “good reason” can be defined for purposes of Code Section 409A. Thus, it is very important that these rules be carefully followed in order to qualify termination payments for the short-term deferral exception to Section 409A of the Code.
Stock options and stock appreciation rights generally will not be subject to Section 409A if (i) the exercise price is no less than the fair market value of the underlying stock on the date the option or SAR is granted and (ii) there will be no deferral of the receipt of the underlying stock (or cash) when the option or SAR is exercised. Thus, discounted stock options and SARs will violate Code Section 409A unless the option/SAR provides for mandatory exercises on specific dates or for the distribution of the stock underlying the option/SAR to be made on a specific date regardless of when the option/SAR was exercised. An amendment to an option or SAR to extend the exercise period is permitted under Code Section 409A only if certain specific rules are followed.
Except in certain specific circumstances, the acceleration of payment of non-qualified deferred compensation is not permitted under Code Section 409A. Furthermore, an amendment to extend the deferral period will be permitted only if certain detailed rules are followed.
Many compensation agreements provide that payments will be made “as soon as possible” after a certain event occurs. In order to make sure that the requirements of Code Section 409A or the exception for short-term deferrals are complied with, it is prudent to set forth the exact date or period during which the payment will be made. In this regard, many arrangements subject to Code Section 409A provide that payments will commence or be made within a certain period of time after the payment triggering event. IRS regulations provide that the period of time cannot exceed 90 days. Thus, for example, a provision in an agreement states that a payment will be made “within 120 days” after an individual’s death will violate Code Section 409A.
Under Code Section 409A, death is a permissible payment trigger. However, a number of non-qualified deferred compensation plans provide that payment of death benefits will be made within a specified period after the employer receives “notice” or “evidence” of death. This would violate Section 409A because it is actual death, and not receipt or notice or evidence of death, that is the permissible triggering event.
June, 2016 Proposed Regulations.
a. On June 21, 2016, the Internal Revenue Service issued proposed regulations that make several changes to the rules governing non-qualified deferred compensation under Section 409A Code. Even though the regulations issued are in proposed form, the IRS stated that taxpayers generally may rely on these new regulations immediately. Please contact me if you desire a detailed description of these proposed regulations.