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.