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Tuesday, March 20, 2012

This post is the fourth in our BenefitsBryanCave.com series on five common Code Section 409A design errors and corrections. Go here, here and here to see the first three posts in that series.

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? Amend the plan to include the six month delay provision, and also provide that the payment will in no event be paid less than 18 months following the date of correction. Penalties would attach in the event of a separation within one year of the date of correction. As always, certain correction documents must be filed with the IRS.

Also, if your company is about to (i) go public, or (ii) be purchased by a public company, you should consider including the six month delay language in your non-qualified plans. Companies generally have until an employee becomes a “specified employee” to include the required language in their nonqualified plan documents.

Click here for other 409A-related posts.

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