Every 409A attorney knows the look. It’s a look that is dripping with the 409A attorney’s constant companion – incredulity. “Surely,” the client says, “IRS doesn’t care about [insert one of the myriad 409A issues that the IRS actually, for some esoteric reason, cares about].” In many ways, the job of the 409A attorney is that of knowing confidant – “I know! Isn’t it crazy! I can’t fathom why the IRS cares. But they do.”
There are a lot of misconceptions out there about how this section of the tax code works and to whom it applies. While we cannot possibly address every misconception, below is a list of the more common ones we encounter.
I thought 409A only applied to public companies. While wrong, this one is probably the most difficult because it has a kernel of truth. All of the 409A rules apply to all companies, except one. 409A does require a 6-month delay for severance paid to public company executives. However, aside from this one rule, all of 409A’s other rules apply to every company.
But it doesn’t apply to partnerships or LLCs. Wrong, although again a kernel of truth. Every company, regardless of form, is subject to 409A. However, the IRS hasn’t yet released promised guidance regarding partnerships or LLCs, most of the 409A rules (like the option rules) apply by analogy.
But I can still change how something is paid on a change of control. Maybe, but maybe not. If a payment is subject to 409A, there are severe restrictions on how it can be modified, even on a change of control. Even payments not subject to 409A by themselves can, inadvertently, be made subject to 409A if the payment terms are modified. There is some latitude to terminate and liquidate plans in connection with a change in control, but – word to the wise – these termination payments are very tricky to implement and require a pretty comprehensive review of all plans in place following the change in control.
409A only affects executives. Nope. Any time “deferred compensation” is implicated, 409A applies, even to rank and file. In fact, 409A can have adverse effects for a mind boggling array of employees, including innocuous arrangements like school-year teacher reimbursement programs!
And the definition of deferred compensation is broad, including such items as severance agreements or plans or even bonuses, if paid beyond the short-term deferral period. As a practical matter, many rank and file severance and bonus plans qualify for exemptions that make them not subject to 409A’s restrictions on time and form of payment, but it’s still worth reviewing them to make sure.
Okay then, it only applies to employees, right? Wrong again. Directors and other independent contractors are subject to 409A’s grip. There are some exemptions, but, again, they are difficult to implement.
What’s the company’s tax burden if we screw up? This question itself is not a misconception, but the unstated assumption – that it’s the company’s liability – is. The penalties fall entirely on the employee, director, or contractor.
But put yourself in the shoes of an executive who, unexpectedly, gets hit with a 409A penalty. The executive may argue that the employer designed the plan and the employer administered the plan. The executive’s role was to work, possibly even contribute his or her own money to the plan, and reap the benefit down the road. The IRS rules say that something got messed up and the executive owes substantial additional taxes – perhaps even before payment is made from the plan – through no fault of the executive.
What’s the first thing the executive does? Turn to the employer and loudly proclaim, “Make me whole.”
In addition, employers can also have additional direct withholding and reporting penalties. Depending upon culpability, those penalties can be very large.
The bottom line is that 409A potentially applies to anyone who hires anyone else to do anything for them – and does not pay them immediately.
On May 18th, two famous, photogenic Olympians found themselves almost $300 million richer. A banner day for anyone, and yet they may have felt at least a twinge of regret. Why? They contend that 409A should have made them much richer, to the tune of as much as $1.2 billion.
At this point, Hollywood has made the story almost old-hat. In December 2002, then Harvard students Tyler and Cameron Winklevoss had an idea. They would develop a web site that connected Harvard students. If successful, they would expand the concept to other campuses. In November of 2003, after several false starts, the Winklevoss twins retained the services of a young, talented programmer to implement their vision. Three months later, without the knowledge of the Winklevoss twins, Mark Zuckerberg gave birth to Facebook. After a successful run at Harvard, the social networking site spread to other campuses, and then took over the world.
In 2004, the Winklevoss twins (and their company ConnectU) filed suit against Facebook, claiming that Mark Zuckerberg had copied their social networking ideas and source code and used them to create Facebook. In 2008, the parties settled, reportedly for $65 million – $20 million in cash and a specified number of shares of Facebook. The problem was the valuation of Facebook stock at the time of the settlement.
Around the time of the settlement, Microsoft made an investment in Facebook. This investment valued Facebook at $15 billion. The Winklevoss twins apparently used this valuation, with a per share price of $35.90, when determining that the number of shares provided as part of the settlement.
How does 409A come in to this story? Like many illiquid startup firms, Facebook made substantial option grants to its employees. For an option to be exempt from Code Section 409A, the option must be granted with an exercise price no less than the fair market value of the underlying stock on the date of grant. Most private start-up companies, particularly ones growing very quickly, regularly engage experienced valuation firm to establish the Company’s fair market value for 409A option grant purposes. Facebook was no exception. In fact, Facebook had come up with an $8.88 per share 409A valuation shortly before the settlement.
After learning of the 409A valuation, the Winklevoss twins sought to invalidate the settlement agreement. Among other things, the twins argued that Facebook’s failure to disclose the $8.88 409A valuation constituted fraud. Had Facebook disclosed the 409A valuation and had that valuation been used in the settlement, the twins would have ended up with more than four times the number of shares they actually received.
Ultimately, the twins lost their appeal to invalidate the settlement, which, after Facebook’s recent IPO, left them with stock purportedly worth around $300 million. Had they used the 409A valuation at settlement, however, their settlement stock could have been worth as much as $1.2 billion.
What’s the moral of this story? Private company stock valuations are inherently speculative, and can be appropriated for purposes other than that for which they are intended. For private companies that issue stock options, 409A can create a paper trail of valuations that can at least raise issues for potential investors, employees, and litigants. Prudence may dictate that companies clearly qualify the limited purpose for which a 409A valuation is obtained (i.e., compliance with 409A). Further, it may be advisable to include confidentiality provisions in stock option agreements and to take such other measures as are necessary to keep private company 409A valuations … well, private.
This post is the fifth and final post in our BenefitsBryanCave.com series on five common Code Section 409A design errors and corrections. Go here, here, here, and here to see the first four posts in that series.
Code Section 409A abhors discretion. One concern with discretion is that it could lead to the type of opportunistic employee action or employer/employee collusion that hurt creditors and employees during the Enron and WorldCom scandals.
Another concern is that discretion could be used opportunistically to affect the taxation of deferred compensation. Consider an employment agreement with a lump-sum payment due at any time within thirteen months following a change in control, as determined in the employer’s discretion. This provision would permit the employer to pick the calendar year of the payment. Because non-qualified payments are generally taxable to the recipient when paid, this type of provision would allow a company to essentially pick the year in which the employee is taxed on the payment. In this situation, the IRS would be concerned that the plan participant (who often has great influence with the company) would collude with the company so that the resulting payment was of most tax benefit to the participant.
Code Section 409A addresses this problem by restricting the timing of a deferred compensation payments following a triggering event to a single taxable year, a period that begins and ends in the same taxable year, or a period of up to 90 days that could potentially span two taxable years. If the “up to 90 day period” approach is taken, Code Section 409A also requires that the service provider not have the right to designate the taxable year of the payment. Most plans provide for payments within a 90 day period following the appropriate Code Section 409A triggering event.
Plans are occasionally drafted using a payment period longer than 90 days. Fortunately, the IRS allows correction of these over-long payment periods. The correction is to amend the plan to either remove the over-long payment period from the plan or to provide for an appropriate period of time for the payment. This amendment can even occur within a reasonable amount of time following the Code Section 409A triggering event, but penalties would apply. As always, certain correction documents must be filed with the IRS.
Code Section 409A is, in part, a response to perceived deferred compensation abuses at companies like Enron and WorldCom. The story of Code Section 409A’s six month delay provision is inextricably tied to the Enron and WorldCom bankruptcies.
Under established IRS tax principles, participants’ rights under a non-qualified plan can be no greater than the claims of a general creditor. Because deferred compensation plans often pay out upon termination of employment, a plan participant with knowledge of a likely future bankruptcy could potentially terminate employment and take a non-qualified plan distribution to the detriment of the company’s creditors (a number or Enron executives with advance knowledge of Enron’s accounting irregularities did just this). This opportunistic cash out is obviously unfair to the company’s creditors. In addition, the cash out only helps hasten the likely bankruptcy because non-qualified plan payments come from the general assets of the company.
How did Congress solve this problem? By requiring that a payment of deferred compensation to any of the most highly compensated employees of public companies (called “specified employees”) be delayed at least six months if the payment is due to a separation from service. The thought was that for public companies (like Enron and WorldCom), plan participants would not have enough time to opportunistically terminate employment and receive payout if the payouts were delayed at least six months following termination.
Code Section 409A requires that the six month delay for specified employees of public companies be codified in the relevant plan document. Generally, plans are drafted so that payments due upon separation from service are delayed the required six months, but only if the terminating employee is a specified employee at the time of termination, and only to the extent such payments are “deferred compensation” within the meaning of Code Section 409A.
What should you do if you work for a public corporation and your high-level employment and severance agreements do not contain the required six month delay language? (more…)
Your company sponsors an annual bonus program. Bonuses are tied to company calendar year performance. The bonus plan says that payments are to occur by March 15th of the year following the performance year. March 15th has always struck you as an odd date.
A friend at another company calls you up, very excited. Her company’s financial performance last year was stellar, and she’s expecting a large payment by March 15th. Another friend at a different company mentions that he’s buying new furniture on the 17th. The proximate cause? Annual bonuses are paid on March 15th.
It is no coincidence that companies often pay out annual bonuses around March 15th. In the case of a company with a calendar year tax year, paying bonuses by March 15 will generally allow the company to deduct the bonuses in the tax year which ends on the prior December 31. But there may be another reason for structuring bonus payouts in this manner: to comply with Code Section 409A.
Code Section 409A generally applies when the right to an amount arises in one year, but the amount can be paid in the next. So, for example, an annual bonus paid shortly after the end of a calendar year could potentially be subject to Code Section 409A.
However, amounts paid by the 15th day of the third month following the end of the year in which the amount “vests” are exempt from Code Section 409A as “short term deferrals.” Thus, March 15th.
But what happens if your company needs to delay scheduled annual bonus payments past March 15th? What if, for example, calculating the company performance for the bonus year takes longer than anticipated, and pushes the payments to March 20th? Surely Code Section 409A doesn’t care about short delays. . .
Code Section 409A cares about most short delays. If your payment is even one day late, it could fall out of the safe confines of the “short term deferral” exception and into the cold and hard rules of Code Section 409A proper. The only exceptions available are for unforeseeable exigent circumstances or because making the payment would jeopardize the company as a going concern. But these exceptions are limited – if there is a practice of regularly making payments after March 15th, there could be Code Section 409A issues.
There is a saving grace. You can structure your bonus plan to both be exempt from Code Section 409A and comply with Code Section 409A’s fixed payment rules. This would require, for example, using a fixed date (e.g. January 1) or period (e.g. January 1 through March 15th) for payment, but providing a March 15th outside payment drop dead date.
What does this approach buy you? If the payment occurs after March 15 but on or before the following December 31, there is no Code Section 409A violation (although there may be a contractual violation).
Let’s say that you are negotiating your CEO’s new employment agreement. Because she is preparing for retirement, the CEO would like to be entitled to a stream of monthly lifetime separation payments upon her voluntary termination. This type of lifetime benefit makes sense for your company, and, based on the CEO’s long and faithful service to the company, you agree.
The CEO then asks for a provision calling for an immediate lump-sum payment upon her involuntary termination. The amount of the payment would be the present value, using reasonable actuarial assumptions, of the monthly separation pay annuity. This request seems reasonable – the fact that things may go sour in the future doesn’t change the fact of the CEO’s long service. And in an involuntary termination situation, who would want to receive payments over a period of time rather than in a lump sum? Should you agree to this request?
No. And regular readers of this blog will not be surprised as to why – Code Section 409A.
Code Section 409A generally requires that payments be made in a single form following each permissible payment triggering event. This means, for example, that a plan couldn’t provide for payment of an amount in a lump-sum if a change in control occurs in a January and a one-year stream of payments if a change in control occurs in a February. Payment forms can differ, however, if the permissible triggering event differs. It is permissible to call for payment of an amount over five years upon separation from service, but call for an immediate lump-sum payment of the same amount upon an intervening change in control.
There are quite a few exceptions to this rule. First, a payment upon a triggering event other than a separation from service can be in different forms on either side of an objectively determinable pre-specified date. For example, a change in control benefit could be paid in a lump-sum if the change in control occurs prior to a plan participant’s attainment of age 55 and could be paid in a life annuity if the change in control occurs after age 55. In essence, this exception permits a plan to “toggle” between two (and only two) forms of payment.
Separation from service payments can potentially “toggle” between three different forms of payment: a normal form of payment, a separate form for separations within up to two years following a change in control, and a final form for separations that occur before or after a specified date (or combination of a date and years of service). For example, an employment agreement could call for the same amount of separation pay to be paid in 36 monthly installments upon separation before age 62, a life annuity upon separation on or after age 62, and in a lump-sum if separation occurs during the year following a change in control.
What to do if your plan impermissibly toggles between forms of payments? The IRS generally permits correction by amending the plan so that the longest permissible forms of payment apply. And if the problematic triggering event occurs within one year of the date of correction, penalties could apply. As always, certain correction documents must be filed with the IRS.
Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections.
It should (but will not) go without saying that Code Section 409A has an extraordinarily broad reach. Many claim this reach is overbroad. One commonly cited example of this overbreadth is that Code Section 409A regulates taxable employee reimbursements.
Why does Code Section 409A regulate reimbursements? The concern is that an employee and employer will collude to achieve reimbursement of extravagant personal expenses many years after the expense is incurred. This “late” reimbursement would have the effect of unreasonably deferring taxation of the reimbursable expense, potentially into a year that is tax-advantageous for the employee.
The IRS’s solution? Ensure that expenses eligible for reimbursement are objectively determinable and reimbursed within a limited period of time following the date in which the expense is incurred. Here’s a list of the IRS’s requirements:
- Definition of Reimbursable Expense. Code Section 409A requires an objectively determinable definition of an expense eligible for reimbursement. The description of the reimbursable expense does not need to be extensive, but does need to be written into the relevant plan document (which could be an employment agreement).
- Prescribed Reimbursement Period. Eligible expenses must be incurred during a prescribed period of time. This period of time can be as long or as short as desired – the lifetime of the service provider works for Code Section 409A purposes. Again, this needs to be written into the plan document.
- Reimbursement Limits Affect Only One Calendar Year. The amount of expenses eligible for reimbursement in one taxable year cannot affect the amount eligible for reimbursement in other taxable years. This requirement must be reflected in the plan document.
- Reimbursement Timing. Reimbursements must occur by the end of the taxable year following the year in which the expense was incurred.
- No Exchange or Liquidation. The right to reimbursement can not be subject to liquidation or exchange for another benefit.
Of these requirements, the requirement that the amount of reimbursements in one year not affect another year is often the biggest stumbling block. Consider, for example, a multi-year employment agreement that, for corporate governance reasons, limits reimbursable expense over the life of the agreement to $20,000. This provision violates Code Section 409A. (more…)
Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections. This is the first of those posts.
You are designing an executive employment agreement with a substantial severance component. For the amount of severance, it seems fair to condition payment upon execution of an agreement waiving all employment claims (ADA, age discrimination, etc.). Why not just say that severance payments don’t begin until the executive returns the claims release? The answer – Code Section 409A.
Incredulous? Here’s the concern. An employee who will begin to receive severance upon return of a release could potentially hold on to the release until the year following his or her termination. What does that achieve? Because the severance is taxable when actually paid, the employee could hold on to a release, defer taxation, and ultimately pay fewer taxes on the severance. Employee discretion as to the timing of taxation exercised opportunistically upon termination of employment is anathema to Code Section 409A.
There are two common solutions to this design problem, both with advantages and disadvantages. (more…)
‘TIS THE SEASON to check executive deferred compensation practices for operational compliance with section 409A of the Internal Revenue Code and the specific terms of company plans and employment agreements.
Common operational errors include deferring too much or too little and making distributions too large, too small, too early or too late.
Even a minor operational error can cause trouble unless it is corrected promptly. Some types of operational errors discovered in the year of the error or one of the next two years can be corrected without ruinous results under IRS procedures. This makes it appropriate to review your 2011 deferral and distribution records to make sure everything is just right or to identify issues and make prompt corrections. If you did not review your records for 2009 or 2010, that also would be worth doing now. Although the corrections approved by the IRS are more difficult and more costly for errors that occurred in the two prior years, making an approved correction is still far better than the onerous taxes imposed on the affected employee if no correction is made.
The correction procedures are described at length in IRS Notice 2008-113. Please call us if we can be of assistance.