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.
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.
Recently, the New York State Department of Taxation and Finance issued an Advisory Opinion regarding whether New York State may impose income tax on distributions from a nonqualified deferred compensation plan made to a former resident. Under federal law, states may not impose income tax on these retirement payments. Plan sponsors that participate in nonqualified deferred compensation plans should be aware of the tax implications of this law.
Click here to view the Alert.