Section Review

409A forces a rethinking of the traditional employment agreement

The American Jobs Creation Act of 2004 added a new provision to the Internal Revenue Code dealing expressly with the tax treatment of nonqualified deferred compensation plans. The prior rules were a patchwork of common law and statutory provisions, all as interpreted and applied by the government, taxpayers and the courts.

New code section 409A evidences Congress’ concern with the state of the law before 2004. It broadly applies to any plan that provides for the deferral of compensation. Generally speaking, the new rules include: (1) qualification requirements that must be met in order to avoid adverse tax consequences, (2) special funding rules that will trigger automatic current taxation if they are not met, and (3) reporting requirements.

If a nonqualified deferred compensation plan does not satisfy the statutory qualification requirements, a service provider will be taxed currently on all compensation deferred under the plan to the extent (a) it is not subject to a substantial risk of forfeiture, and (b) it was not previously included in income. There is also an excise tax, and there may be a deferral charge. First, the income tax imposed on currently taxable deferred compensation is increased by 20 percent. Second, interest at the underpayment rate plus 1 percent will be imposed on the underpayments that would have occurred had the deferred compensation been includable in the employee’s gross income for the taxable year in which it was first deferred or, if later, the year in which it was no longer subject to a substantial risk of forfeiture.

To avoid these negative tax consequences, each arrangement must, on a perparticipant basis, satisfy three specific rules. First, distributions may not occur earlier than one of six specified times. Second, the time and form of payment must be fixed when the compensation is deferred. Finally, if a service provider has an elective right to defer benefits, specific statutory criteria relative to deferral decisions apply.

Code Section 409A has added a new dimension to the drafting of employment agreements. Some guidelines for drafters under the new regime are set forth below.

Guideline No. 1: Be on the lookout for any benefits that may involve a deferral of compensation.

A deferral of compensation will exist if an employee has a legally binding right to remuneration in Year 1 that, under the provisions of his or her work arrangement, can be paid in Year 2 or in any later year.

If an employer can unilaterally eliminate a benefit, the employee eligible for that benefit will not have a legally binding right to it. On the other hand, if the benefit is simply forfeitable as a result of events that may or may not occur in the future, the employee will nonetheless hold a legally binding right.

Guideline No. 2: Become familiar with deferral arrangements that are clearly outside of the scope of 409A, no matter what.

Some compensation arrangements fall outside of the scope of code section 409A even though they involve an element of deferral. For drafters of employment agreements, there are two particularly useful categories of excluded items.

First, all qualified employer plans are exempt. Certain welfare benefit arrangements are also exempt. These include the perks that employees expect to receive — such as vacation time, sick leave, compensatory time, disability pay and death benefits, as well as health insurance benefits that are excludable from gross income under other code provisions.

Guideline No. 3: Inquire about an employee’s stock rights, which may not always be safe from attack under 409A.

The government has also helpfully excluded a number of stock rights from coverage under code section 409A, although not all stock rights are safe.

Incentive stock options

So-called incentive stock options and options granted under a code section 423 employee stock purchase plan do not constitute deferred compensation. However, an incentive stock option that later becomes a non-statutory stock option could then become subject to code section 409A.

Non-statutory stock options

Code Section 409A applies to some, but not all, non-statutory stock options. Exempt non-statutory options can be provided only with respect to so-called service recipient stock. This is essentially common stock of the employer or of any corporation that controls the employer. In addition, an exempt non-statutory option must be granted at a price equal to the fair market value of the shares subject to the option on the date of grant. An independent outside appraisal will normally establish the fair market value of nonpublicly traded stock, but most non-publicly traded companies are reluctant to pay for periodic appraisals of their common stock.

Stock appreciation rights

Using stock appreciation rights (SARs) to circumvent the difficulties presented by nonstatutory options will not work. SARs are analyzed under the same principles that apply to non-statutory options.

Restricted stock

Finally, in most cases, code section 409A does not impact restricted stock. The restricted stock need not be vested when it is issued. It is important to keep in mind, however, that restricted stock units are not the same as restricted stock. The regulations state that a plan under which an employee is given a legally binding right to receive property in a later year that will, at that time, be substantially vested may be a plan to which the provisions of code section 409A apply.

Guideline No. 4: Know how to keep separation pay off the list of compensation subject to 409A.

Involuntary separation pay

Separation pay is deferred compensation to which the provisions of code section 409A may apply. However, the regulations provide that involuntary separation pay (not also due if an employee voluntarily quits without cause) is not subject to code section 409A. An involuntary separation may occur if:

  • An employer fails to renew an employee’s employment contract when the contract expires, and the circumstances show that the employee was willing and able to enter into a new contract.
  • The separation occurs for “good reason” — either (a) applying the safe harbor definition in the regulations, or (b) on the basis of all relevant facts and circumstances.

Under the safe harbor definition of good reason in the regulations, the separation from service must occur during a period not to exceed two years after the initial existence of one or more of six enumerated conditions that arise without an employee’s consent (such as a material diminution in his or her base compensation, or in his or her duties or responsibilities). In addition, the employee must give his or her employer notice of the relevant conditions and an opportunity to remedy the problem (both within the time periods set forth in the regulations). Finally, the separation pay must be identical to that due in the case of an actual involuntary separation from service (taking into account the amount, time and form of payment).

Once the involuntary nature of a separation has been determined to exist, two other regulatory conditions must be addressed. First, there is a ceiling on the amount exempt from code section 409A (although being over the ceiling does not disqualify the ceiling amount). The limit is twice the lesser of two amounts:

  1. the maximum compensation that may be taken into account under a qualified retirement plan for the year in which the separation from service occurs (for 2008, the limit is $230,000), or, if greater,
  2. the employee’s annualized compensation, based upon his or her annual rate of pay for services provided in the year before the year in which the separation from service occurs (an employees “annual rate of pay” may possibly include a regular bonus).

In addition, the involuntary separation pay must be paid to the employee no later than his or her second taxable year after that in which the separation from service occurs.

Other special separation payments

Other special forms of separation pay may fall outside of the scope of code section 409A, without regard to the circumstances under which they are paid. The following benefits will not be treated as nonqualified deferred compensation, even if they are paid when an employee voluntarily separates from service:

  • Reasonable outplacement expenses, reasonable moving expenses directly related to the termination of services, and deductible employee business expenses — if they are due by the end of the employee’s second taxable year after that in which he or she separates from service.
  • Reimbursements for medical expenses not covered by health insurance, for a period of time coterminus with the end of COBRA continuation coverage following the employee’s termination of employment.
  • On an elective basis, payments not in excess of the code section 401(k) elective deferral limit for the year in which the separation from service occurs (now $15,500).

Guideline No. 5: Become familiar with the short-term deferral rule that can take a lot of benefits off the table, such as bonuses and separation pay not otherwise excluded.

By regulation, short-term deferrals are also exempt from code section 409A. When determining the relevance of this exception, it is important to focus on two things — (a) when benefits are no longer subject to a substantial risk of forfeiture, and (b) when they are to be paid. Compensation will be deemed not to have been deferred if an employee actually or constructively receives it before the last day of a defined two-and-a-half month period. The relevant two-and-a-half month period ends on the 15th day of the third month following the end of the employee’s (or, if later, the employer’s) first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture.

The short-term deferral rule will not apply if a payment may, under the circumstances, be made or completed sometime after the end of the applicable two-and-a-half month period under the terms of the plan as written. On the other hand, if there is no written provision dealing with when a payment is to be made, a payment actually made within the two-and-a-half month period will not be treated as deferred compensation. However, it is recommended that drafters of employment agreements not rely upon this helpful regulatory provision.

The essential problem with the short-term deferral rule is that it requires payment within a certain period of time after benefits cease to be subject to a substantial risk of forfeiture. In many cases, an employee may be entitled to benefits under his or her employment agreement with respect to which there is no substantial risk of forfeiture, but which are due at some point in the future — such as, upon separation of service for any reason. Under these circumstances, the short-term deferral provision will not apply.

Guideline No. 6: If all else fails, know how to satisfy the requirements of 409A.

(a) Make sure you have a good payment trigger.

Under code section 409A, benefits to which the provision applies may be paid only when certain events occur. Four of the enumerated events are likely to be relevant to employment agreements. Death is one of them, as is disability. The definition of disability in the statute and the regulations is a strict one. An employee is considered to be disabled if (i) he or she is unable to engage in any substantial gainful activity as a result of any medically determinable physical or mental impairment that can be expected to end in death or to continue for at least 12 months, or (ii) because of such an impairment, the employee is receiving income replacement benefits for not less than three months under his or her employer’s accident and health plan. The regulations permit a plan to deem an employee to be disabled if he or she has been determined to be totally disabled by the Social Security Administration.

Section 409A compliant payments may also be made upon a change in the ownership or effective control of the employer, or in the ownership of a substantial portion of the employer’s assets. Important to note here is that an employer may wish to define a change of control differently from the way in which it has been defined in the regulations. This effectively means that the employer’s definition may be used for purposes of determining when benefits vest, but not when they can be paid.

In most situations, the most important payment event is “separation from service.” The regulations state that an employee separates from service if he or she dies, retires or otherwise has a termination of employment. For drafters of employment agreements, two aspects of this definition are important to bear in mind:

  • The government takes the position that an employment relationship will remain intact while an employee is on a bona fide leave of absence of up to six months, or longer if the employee’s reemployment rights are protected by statute or contract.
  • A termination of employment is irrebuttably presumed when an employee’s bona fide level of services permanently falls to no more than 20 percent of the average performed by him or her over the prior 36 months.

To preclude inadvertent terminations of employment within the meaning of the regulations, employment agreements might, for example, preclude an employer from significantly reducing an employee’s hours of service without his or her consent.

(b) Make sure you have a good payment method.

The regulations include a lengthy discussion of the ways in which benefits to which code section 409A applies may be paid. As a general matter, a plan may provide only one time and form of payment upon the occurrence of one of the enumerated permissible payment events. For example, benefits might be paid in the form of a lump sum upon an employee’s separation from service, and in a different manner in the event of a change in the ownership or effective control of his or her employer.

Also, under limited circumstances, the government permits a different time and form of payment when a separation from service occurs (a) during a period of up to two years following a change in control, (b) before or after a specified date, such as attainment of age 65, or (c) before or after both a specified date and a specified period of service under a nondiscretionary formula.

Separation from service is defined to include disability and death. Thus, it appears that benefits due on account of disability or death must be paid in the same manner as benefits due upon separation of service for any other reason. The wording of the regulations leads one to this conclusion, notwithstanding its apparent inconsistency with the statute’s treatment of death and disability as separate payment events.

The regulations provide that when a payment event occurs, a plan can designate, as the payment date, (a) the date of the event, or (b) another payment date objectively determinable and nondiscretionary at the time the payment event occurs.

Methods of payment may also vary. Payments may be scheduled, or may commence or occur in a designated taxable year of the employee. Also, payments may occur during a designated period, so long as (a) it begins and ends within one taxable year of the employee, or does not exceed 90 days, and (b) the employee cannot select the year of payment. In all cases, the payment schedule and the designated taxable year or payout period must be objectively determinable and nondiscretionary when the payment event occurs. It will normally not be possible to accelerate payments because of antiacceleration provisions in the statute.

(c) Do not overlook two special provisions dealing with methods of payment.

Two special distribution provisions are of particular relevance to drafters of employment agreements. One deals with reimbursements subject to code section 409A, and the other deals with amounts payable to so-called specified employees following their separation from service.

Reimbursements

An employer will often agree to reimburse an employee for expenses, even after his or her termination of employment. Since it is uncertain when an expense will be incurred, reimbursements not exempt from code section 409A are deferred compensation. Special payment provisions in the regulations permit reimbursements to satisfy the requirements of code section 409A. Among other things, the reimbursement program must define the expenses eligible for reimbursement in an objectively determinable and nondiscretionary manner, and an eligible expense must be reimbursed before the last day of the employee’s taxable year after that in which the expense is incurred.

Specified key employee rule

Another special distribution provision impacts key employees. Every plan of deferred compensation to which the provisions of code section 409A apply must, by its terms, provide that distributions to a so-called specified employee cannot be made before the date that is six months after the employee’s separation from service, or, if earlier, the date of the employee’s death. This provision must appear in the plan immediately before an employee becomes a specified employee.

In general, a specified employee is one who, when his or her separation from service occurs, is a key employee of an employer whose stock is then publicly traded on an established securities market. The statute imports the key employee definition from those code provisions dealing with top-heavy retirement plans.

Guideline No. 7: Re-review the draft agreement to ensure either that 409A does not apply or that all 409A requirements have been met.

©2014 Massachusetts Bar Association