1. Cash payments calculated by reference to benefits provided under an ERISA plan do not “relate to” an ERISA plan for purposes of determining ERISA preemption issues.
2. Attempts to bring executive severance payments and benefits within the scope of ERISA raise a variety of tax and benefits issues that require careful consideration.
As noted in our blog entry on October 16, 2012, under the Sixth Circuit’s discussion in U.S. v. Quality Stores, severance payments made because of an employee’s involuntary separation resulting from a reduction-in-force or discontinuance of a plant or operation are not subject to FICA taxes. This holding is contrary to a prior decision of the Federal Circuit Court of Appeals and published IRS guidance. The government has until May 3 to appeal the case to the Supreme Court. Until a final decision in this case has been rendered, taxpayers that have made severance payments in 2009 should file a protective claim for a FICA tax refund no later than April 15, 2013. This protective claim will preserve the taxpayer’s right to a refund should the IRS not appeal the decision or should the decision be upheld on appeal.
Last month the SEC issued a no-action letter to a financial services firm that sheds light on the scope of the prohibition under Section 402 of the Sarbanes-Oxley Act of 2002 which makes it unlawful for an issuer to “extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or any executive officer . . . of that issuer.”
Historically, the SEC appears to have been reluctant to issue formal guidance respecting the parameters of the loan prohibition under Section 402. Common arrangements left in limbo by this lack of regulatory guidance extend to personal use of company credit cards, personal use of company cars, travel-related advances, and broker-assisted option exercises.
The SEC’s no-action letter was issued to RingsEnd Partners, a financial services firm. The letter addresses a program established to facilitate the payment of taxes associated with the grant of restricted stock awards. Under this program, recipients of restricted stock awards make a qualifying election to be taxed on those shares at the time of grant (a so-called 83(b) election) and then transfer those shares to a trust administered by an independent trustee who is directed to borrow funds from an independent bank through non-recourse loans sufficient in amount to pay the tax liability incurred as a result of the stock awards. Through this mechanism, recipients of these awards can retain ownership of all shares granted to them rather than sacrificing a number of those shares necessary to pay applicable tax obligations. To facilitate utilization of the program, however, an employer is involved in a variety of administrative actions necessary to maintain the program, including delivering the share awards to the trust, providing information to the lending institution and delivering prospectuses and registration statements covering the shares to the trustee. All administrative costs associated with administering the trust are borne by those recipients electing to participate in the trust.
The SEC concluded that employers whose employees where involved in this program would not by their administrative activities be deemed to be in violation of the prohibitions of Section 402. The conclusions reached by the SEC in this case would appear to be very instructive in reaching conclusions about the permissibility of other more common practices that would appear to involve arrangements that are no more administratively intensive, such as broker-assisted option exercises.
Section 162(a) of the Internal Revenue Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the year in carrying on a trade or business, including “reasonable compensation for personal services actually rendered.”
The reasonableness of compensation is a question of fact. A taxpayer is entitled to a deduction for salaries or other compensation if the payments were reasonable in amount and are in fact payments purely for services.
Sometimes it is difficult to determine whether amounts are “reasonable,” especially when payments are made to a shareholder-employee or the shareholder’s relatives.
A ruling by the U.S. Tax Court on March 25, 2013, provides a helpful analysis of 10 factors considered by the Court in deciding that amounts deducted as compensation paid to a sole shareholder-employee, his officer-wife, employee-brother and employee-daughter were not reasonable. (K & K Veterinary Supply, Inc. v. Commissioner, T.C. No. 9442-11, T.C. Memo 2013-84, 3/25/2013).
Compensation Reasonableness Factors
The following is a brief summary of the 10 factors discussed by the Court:
- Employee Qualifications. An employee’s superior qualifications for his or her position with the business may justify high compensation.
- Nature, Extent and Scope of Employee’s Work. An employee’s position, duties performed, hours worked, and general importance to the company’s success may justify high compensation.
- Size and Complexity of the Business. The size and complexity of a taxpayer’s business may warrant high compensation. This assessment may include consideration of a company’s sales, net income, gross receipts, or capital value, as well as the number of clients, and the number of employees of the company; growth in these areas; and compliance with government regulations.
- General Economic Conditions. General economic conditions may affect a company’s performance. This factor may be relevant, for example, in connection with adverse economic conditions where the taxpayer may show that an employee’s skill was important to the growth of the company during lean years.
- Comparison of Salaries Paid With Gross and Net Income. Compensation as a percentage of a taxpayer’s gross or net income may be important in deciding whether compensation is reasonable.
- Prevailing Rates of Compensation. The Court considered prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry as “a most significant” factor. Both the taxpayer and the Commissioner relied on expert reports and testimony to support this factor.
- Salary Policy of the Taxpayer as to All Employees. The amount of compensation paid to all employees may be a factor that supports a high level of compensation. Whether the company pays top dollar to all of its employees, including both shareholders and non-shareholder employees may be relevant in assessing the pay of shareholder-employees. Evidence of a reasonable, longstanding, consistently applied all-employee compensation plan may support that the compensation paid was reasonable.
- Compensation Paid in Previous Years. The amount of compensation paid in previous years may support a high amount of compensation for a tax year. This factor will likely only be relevant where the company is deducting compensation in one year for services rendered in prior years.
- Comparison of Salaries With Distributions and Retained Earnings. The reasonableness of compensation may take into account the absence of dividend payments by a profitable corporation. Because a corporation is not required to pay a dividend, the company’s return on equity may be a better measure of this factor.
- Debt Guaranty. The Court also considered whether an employee personally guaranteed the taxpayer employer’s debt.
The Court considered these various factors and noted that some factors favored the taxpayer, other factors favored the Commissioner, and other factors were either neutral or did not apply.
Expert Reports and Testimony
After giving “due weight” to each of the factors, the Court found the report of the Commissioner’s expert on prevailing rates of compensation, supported by individual company information and financial data, as “persuasive.” In contrast, the report of taxpayer’s expert provided “guidance of dubious value” because it failed to identify comparable companies by industry or size and the expert did not provide any financial analysis or relevant financial data.
Unreasonable Rent and No Equitable Recoupment
In addition to finding that amounts paid as compensation to the officers (shareholder-employee and his officer-wife) and certain employees (the shareholder’s brother and daughter) were not reasonable, the Court ruled on two related issues. The Court disallowed a deduction for certain amounts paid by K & K Veterinary Supply, Inc. as rental expenses to a related entity (an entity owned 100% by the shareholder-employee and his officer-wife). The taxpayer then unsuccessfully argued that the disallowed portions of the compensation and rent were dividends taxable at a lower rate – using the doctrine of equitable recoupment.
The Tax Court in Neff v. Commissioner, TC Memo 2012-244 (8/27/2012) recently ruled on the income tax consequences of the termination of a split dollar life insurance arrangement (“SDLIA”), in ruling that the payment of a discounted amount by the employees on the termination of the SDLIA resulted in the recognition of income to the employees to the extent of the difference between the amount owed to the corporation under the SDLIA and the amount the employees paid. The Tax Court did not address the issue of the extent the equity portion of a SDLIA may be subject to income taxation on the termination of the SDLIA as that issue was not raised by the Service nor addressed by the Tax Court.
This case involves a pre-final regulation SDLIA to which the final regulations do not apply. Rather Rev. Ruls. 64-328 and 66-110 and Notice 2002-8 apply to determine the income tax consequences of the rollout of the SDLIA. Here the two employees/owners of the J & N Management Company (the “Company”) entered into split dollar arrangements whereby the Company was obligated to pay the premiums on six life insurance policies owned by the employees and family limited partnerships of the employees. In return, the Company was entitled to receive the lesser of the premiums paid and the cash value of the policies on the termination of the SDLIA. By the end of 2003, the Company had paid $842,345 in premiums and the cash value of the policies was $877, 432. The employees and the Company orally agreed to terminate the SDLIA with the employees paying the Company the discounted present value of the right to receive the premiums paid at the death of the employees. However, the Company was entitled to reimbursement of the premiums paid on the termination of the policy and were not required under the terms of the SDLIA to wait until the death of the employee to recover those funds. As a result of discounting the value of the Company’s entitlement, the employees paid the Company $131,969 instead of the $842,345 owed to the Company on termination of the SDLIA, and the Company released its interest in the policies. The IRS then included the difference of $710,376 in the taxable income of the employees for 2003 and assessed an income tax deficiency.
The Tax Court ruled that Neff and Jensen received substantial value from the Company related to their employment when they ended up with unrestricted rights to the remaining cash value of the policies, and that as a result, Neff and Jensen realized taxable compensation income. The Tax Court stated that “each year an SDLIA was in effect, an employee was required to include in taxable income the total value or cost of the economic benefit received each year by the employee, less any amount contributed by the employee.” However, the Tax Court noted that Neff and Jensen had not included any amount in income. Interestingly, the government did not assess a tax deficiency on this failure to include the economic benefit in taxable income for the several years the SDLIA was in place. Had the taxpayers included such economic benefit in taxable income, they could have asserted that they were entitled to a reduction in the taxable income from the economic compensation income on termination of the SDLIA.
The Tax Court then held that, notwithstanding the arguments of the taxpayers, the transaction constituted “an effective rollout of the SDLIAs and that the equity split dollar life insurance arrangements were terminated” despite the absence of a written termination agreement, and that as a result, Neff and Jensen realized the economic benefit of the difference between the premiums paid by the Company and the discounted amount repaid to the Company by Neff and Jensen, which economic benefit was includible in their taxable income.
The Tax Court did not rule on, and was not presented with, the question of the extent to which the equity in the policies at the time of the termination of the SDLIA, the difference between the premiums paid of $842,345 and the cash value of $877,436, would also be taxable to the employee on pre-final regulation policies on termination of the SDLIA. Therefore, the practitioner cannot assume that this equity would not be includible as taxable income on rollout of a SDLIA. At most, this case stands for the proposition that these taxpayers were not called upon to defend the inclusion of such equity in their taxable income. Perhaps this was because the easier case was the includibility of the economic benefit of not having to repay the Company the full amount of the premiums paid, and the amount of the equity on termination of these policies was small in relation to this much larger economic benefit.
As a final note, the Tax Court declined to impose a § 6662(a) penalty on the taxpayers, stating that the taxpayers “acted with reasonable cause and in good faith in relying on their professional tax advisers…” Really?? Was it really reasonable for Neff and Jensen to assume they could be relieved of the obligation to repay the Company for the $842,345 in premiums paid with a repayment of $131,969 without any income tax consequences?
It’s that time of year again! Time to ensure year-end executive compensation deadlines are satisfied and time to plan ahead for 2013. Below is a checklist of selected executive compensation topics designed to help employers with this process.
I. 2012 Year-End Compliance and Deadlines
□ Section 409A – Amendment Deadline for Payments Triggered by Date Employee Signs a Release
It is fairly common for an employer to condition eligibility for severance pay on the release of all employment claims by the employee. Many of these arrangements include impermissible employee discretion in violation of Section 409A of the Internal Revenue Code because the employee can accelerate or delay the receipt of severance pay by deciding when to sign and submit the release. IRS Notice 2010-6 (as modified by IRS Notice 2010-80), includes transition relief until December 31, 2012 to make corrective amendments to plans and agreements.
Generally, the arrangement may be amended to either (1) include a fixed payment date following termination, subject to an enforceable release (without regard to when the release is signed), or (2) provide for payment during a specified period and if the period spans two years, payment will always occur in the second year. We recommend employers review existing employment, severance, change in control and similar arrangements to ensure compliance with this payment timing requirement. The December 31, 2012 deadline for corrective amendments is fast approaching.
□ Compensation Deferral Elections
Compensation deferral elections for amounts otherwise payable in 2013 must generally be documented and irrevocable no later than December 31, 2012. The remainder of 2012 is sure to pass quickly, especially with the added distractions of the elections and tax law uncertainty. Employers should consider additional communications to ensure the deadline is not overlooked. (It’s also a good time to confirm 409A compliance generally, as we have discussed previously.)
□ Payroll Deduction True-Up for Fringe Benefits and Other Compensation
Some employers utilize a rule for administrative convenience that permits income and employment tax withholding on certain items of compensation to be made at the end of the year (i.e., imputed income on after-tax long-term disability premiums). Employers should ensure that all payroll deductions for taxable compensation for the year are taken into consideration.
□ Annual Compensation Risk Assessment for SEC Reporting Companies
Beginning with the 2010 proxy season, companies have been required to perform a risk assessment of their compensation policies and practices. The purpose of the assessment is to evaluate compensation-related risk-taking incentives. Where a company determines that its employee compensation program includes “risky” pay policies and practices, it must include disclosures (including mitigating practices). In recent addresses, representatives of the SEC have included a “reminder” to public companies that the compensation risk assessment must be performed annually.
□ Compensation Consultant Conflict of Interest Assessment for SEC Reporting Companies
Beginning with the 2013 proxy season, the Dodd-Frank Act requires a company to disclose whether the work of its compensation consultant has raised any conflict of interest. The assessment should consider six specified factors outlined in the rules. The purpose of the assessment is to determine whether the work of the consultant raised a conflict of interest. If the company determines a conflict of interest was raised, the company must disclose the nature of the conflict and how the conflict is being addressed.
II. 2013 Planning
□ Section 162(m) Employer Compensation Deduction Limit
Section 162(m) of the Internal Revenue Code limits the deduction for a publicly-held corporation to $1 million for each covered employee (typically the chief executive officer and four most highly compensated officers, other than the CEO and CFO). This deduction limit does not apply to “qualified performance-based compensation.” To qualify for the exception, the compensation must be payable solely on account of the attainment of one or more pre-established performance goals and other technical requirements must be satisfied. Employers should review their plan design and administrative practices to ensure compliance with the technical requirements. For example: (1) review the timing of prior shareholder approval to determine whether new shareholder approval must be obtained in 2013, (2) confirm that the compensation committee is comprised solely of two or more “outside directors,” and (3) ensure that the committee timely establishes the performance goals for the new performance period, and pre-certifies the level of achievement of the performance goals at the end of each performance period. A few other technical requirements to note include:
- If the company issues restricted stock and restricted stock units (RSUs) that are designed to qualify as performance-based compensation, any related dividends and dividend equivalents must separately satisfy the performance-based compensation requirements (i.e., must be contingent on achievement of the performance goals).
- It is common for a shareholder-approved equity plan to include a per-employee share limit for a stated period for awards granted under the plan. It is important for the company to keep track of this limit to ensure actual awards do not exceed this cap.
New for 2013 – Deduction Limit for Health Insurance Providers and Related Entities
A new provision enacted under the Health Care Reform law takes effect on January 1, 2013. New Section 162(m)(6) of the Internal Revenue Code limits the deduction covered health insurance providers (and their related entities) may take for compensation paid to certain employees in excess of $500,000. There is no performance-based compensation exception to this limit.
□ Monitor Tax Law Changes
There are a number of tax law changes scheduled to occur beginning in 2013 that will impact required income and employment tax withholding for many forms of executive and equity compensation. Congress could act to extend some tax rate cuts beyond 2012. We recommend employers monitor tax law developments and be prepared to make changes to current payroll reporting processes. Below are some of these changes:
Employment Taxes. On October 16, 2012, the Social Security Administration announced employment tax rates for 2013. The taxable wage base for earnings subject to the Social Security tax for 2013 is $113,700, up from $110,100 in 2012. In addition to an increase in the Social Security taxable wage base, the tax withholding rate is scheduled to return to 6.2% (the temporary 4.2% reduced rate is scheduled to expire at the end of 2012). The Medicare tax also applies and the required withholding rate is an additional 1.45% with no wage limit. Starting in 2013, an additional Medicare tax of 0.9% applies to earnings from wages and other taxable compensation over a threshold amount (i.e., $200,000-$250,000 based on filing status).
Supplemental Wage Withholding. The supplemental wage withholding rate is used by employers for income tax withholding on bonus, commissions, severance payments, equity awards and other special payments. The supplemental wage withholding rate for 2012 is 25% or a mandatory 35% once aggregate supplemental wages exceed $1 million for the year. Due to the scheduled expiration of the Bush-era tax cuts, the 2013 rates are scheduled to increase to 28% and 39.6% for aggregate amounts in excess of $1 million.
□ Proxy Statement Preparation for SEC Reporting Companies
With the implementation of Say on Pay, proxy statement disclosures serve as a key investor communication tool to help explain the company’s compensation program and how it ties to company performance. Now is the time to improve disclosures and implement best practices for the upcoming proxy season. Below are some areas for consideration:
On October 16, 2012, Institutional Shareholder Services (ISS) issued for comment several proposed proxy voting policy changes. The following would affect U.S. public companies:
Current Policy: Recommend vote against or withhold votes from the entire board (except new nominees, who are considered case-by-case) if the board failed to act on a shareholder proposal that received the support of either (i) a majority of shares outstanding in the previous year; or (ii) a majority of shares cast in the last year and one of the two previous years.
Proposed Policy: Recommend votes against or withhold votes from the entire board (with new nominees considered case-by-case) if it fails to act on any proposal that received the support of a majority of shares cast in the previous year.
The proposed change is intended to increase board accountability. ISS is specifically seeking feedback as to whether there are specific circumstances where a board should not implement a majority-supported proposal that receives support from a majority of votes cast for one year.
Say-on-Pay Peer Group
Current Policy: ISS’s pay-for-performance analysis includes an initial quantitative screening of a company’s pay and performance relative to a group of companies reasonably similar in industry profile, size and market capitalization selected by ISS based on the company’s Standard & Poor’s Global Industry Classification (GICS).
Proposed Policy: For purposes of the quantitative portion of the pay-for-performance analysis the peer group will continue to be selected from the company’s GICS industry group but will also incorporate information from the company’s self-selected benchmarking peers. When identifying peers, ISS will afford a higher priority to peers that maintain the company near the median of the peer group, are in the company’s own selected peer group and that have selected the company as a peer.
The change is likely a direct response to criticism from companies that the ISS-selected peer groups are not comparable and in many cases do not take into account multiple business lines. ISS is specifically requesting comments on whether there are additional or alternative ways that ISS should use the company’s self-selected peer group, what size range (revenue/assets) should be used for peer group determination and what other factors should be considered in constructing the peer group for pay-for-performance evaluation.
Say-on-Pay Realizable Pay Analysis
Current Policy: If the quantitative pay-for-performance screening demonstrates unsatisfactory long-term pay for performance alignment or misaligned pay, ISS will consider grant-date pay levels or compensation amounts required to be disclosed in the SEC summary compensation table to determine how various pay elements may work to encourage or to undermine long-term value creation and alignment with shareholder interests.
Proposed Policy: Rather than focusing solely on grant-date pay levels, the qualitative analysis for large-cap companies may include a comparison of realizable pay to grant-date pay. Realizable pay will consist of relevant cash and equity-based grants and awards made during the specific performance period being measured, based on equity award values for actual earned awards or target values for ongoing awards based on the stock price at the end of the performance measurement period.
In its recent annual survey, 50% of investors indicated that they consider both granted and realized/realizable pay as an appropriate way to measure pay-for-performance alignment. ISS has requested comments as to how to define realizable pay, whether stock options should be considered based on intrinsic value or Black-Scholes value and under what rationale and what should be an appropriate measurement period for realizable pay. (more…)
On September 7th, 2012, the 6th Circuit upheld the District Court’s decision in U.S. v. Quality Stores, holding that severance payments made to employees in connection with an involuntary reduction in force were not “wages” subject to FICA taxes. United States v. Quality Stores, Inc. (In re Quality Stores, Inc.), 424 B.R. 237 (W.D. Mich. 2010), aff’d, 10-1563, 2012 U.S. App. LEXIS 18820 (6th Cir. September 7, 2012). In so holding, the 6th Circuit reasoned that such severance payments were supplemental unemployment compensation benefits (“SUB Pay”) within the meaning of § 3402(o)(2) of the Internal Revenue Code (the “Code”) exempt from FICA taxes.
This holding is directly at odds with the position of the Internal Revenue Service (“IRS”), set forth in Revenue Ruling 90-72, that such severance payments are wages for FICA purposes and not SUB Pay. According to the IRS, the definition of SUB Pay in § 3402(o)(2) of the Code is not applicable for FICA purposes. The IRS has defined SUB Pay for FICA purposes through a series of revenue rulings. Under the IRS definition, SUB Pay must be linked to the receipt of state unemployment compensation and must not be received in a lump sum in order to be excludable from wages for FICA purposes. The 6th Circuit rejected the IRS definition reasoning that Congress intended the same definition to apply for both FICA and income tax withholding purposes and that, to the extent that Congress has permitted the IRS to decouple the definition, it must be done by regulation and not by administrative rulings.
The IRS may issue a nonacquiescence and petition the U.S. Supreme Court for certiorari. The petition may be granted because this decision has created a split in the courts. In CSX Corp. v U.S., 518 F.3d 1328 (Fed. Cir. 2008), the Federal Circuit Court of Appeals held that the severance payments at issue were subject to FICA taxes.
Employers may be entitled to a FICA tax refund for FICA taxes paid on severance payments made pursuant to an involuntary reduction in force, the discontinuance of a plant or operation or other similar condition. As a result, employers who made severance payments in any open year under these circumstances may want to assert a protective claim by filing Form 941-X prior to the applicable statute of limitations deadline. A protective claim must be filed by April 15, 2013 for payments made in 2009. In the meantime, employers should continue to treat such payments as subject to FICA taxes pending further developments.
In a decision released on June 29, the Delaware Chancery Court (a trial court) in Seinfeld v. Slager (no, not that Seinfeld) allowed an allegation of corporate waste to survive a motion to dismiss. The allegation: that directors wasted corporate assets by granting themselves restricted stock units in an excessive amount. The case is significant in part because the court is widely regarded as a leading court on corporate governance issues.
This case is interesting because, most often, compensation of non-employee directors is protected under the “business judgment rule” that basically prevents courts from second-guessing the decisions of a board of directors. However, the business judgment rule is generally not available for transactions where directors have a financial interest that could reasonably compromise their independent judgment. In asserting the protection of the business judgment rule, the directors argued that the stock plan under which the awards were granted was stockholder approved and provided a maximum number of 1,250,000 shares that could be subject to an award to any eligible recipient in a year.
This stockholder approval, the defendant directors argued, cleansed their self-interestedness because they were merely implementing the terms of a stockholder-approved plan. In essence, the directors argued that any grants below the stockholder-approved cap were not self-interested because the directors were acting within parameters approved by stockholders. However, the court said, “Though stockholders approved this plan, there must be some meaningful limit imposed by the stockholders on the Board for the plan to be consecrated by [prior case law] and receive the blessing of the business judgment rule [as a result of stockholder approval].” (emphasis in original). With a stock value of $24.79 per share, the maximum meant that each director could receive tens of millions of dollars of compensation and the court did not find that limit to be meaningful enough to survive a motion to dismiss.
Depending on how this litigation progresses through the trial and appellate levels, companies may want to consider including hard-wired grants or maximum share limits, or reevaluating any limits they already have, going forward. If a maximum number of shares or maximum dollar value that non-employee directors can receive in a given year is in the plan, it should be sufficiently tailored so as not to create the ability to grant excessive director compensation. Additionally, if a plan has a maximum number of shares, that number may need to be revisited (and reduced) as the company’s stock price increases.
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.