Beyond the basics of Internal Revenue Code Section 409A

David A. Guadagnoli and Amy E. Sheridan,
The Daily Record Newswire

Savvy lawyers used to advise that tax considerations should never drive a business deal. The passage of Internal Revenue Code Section 409A in 2004 upended that paradigm.

Section 409A applies to all "nonqualified deferred compensation," a concept defined broadly in the statute, regulations and Internal Revenue Service guidance. The complex and sometimes subtle provision must now be taken into account when drafting virtually every employment, separation and change in control agreement as well as equity incentive and other compensatory arrangements.

An employee or independent contractor who has a legally binding right (vested or not) to receive compensation at some point in the future is potentially subject to Section 409A.

The failure to satisfy Section 409A in both form and operation can result in potentially huge penalties on the service provider consisting of accelerated income inclusion at vesting, a 20 percent excise tax, and a possible additional interest surcharge. A service recipient is subject to withholding and reporting obligations with respect to non-compliant Section 409A arrangements.

The failure to satisfy the intricacies of Section 409A therefore poses serious risks for you and your clients. This article briefly reviews the most common Section 409A problems that arise in employment-related agreements and discusses just a few of the more complicated Section 409A situations we have dealt with that, on their face, seemed relatively straightforward.

Bonus provisions

Employment agreements often provide for annual or other periodic bonus payments. Section 409A is not implicated in the case of "short-term deferrals," which are amounts paid within two and a half months after the end of the year in which the right to payment becomes fixed (in the language of Section 409A, the amount is no longer subject to a "substantial risk of forfeiture").

Determining what constitutes a substantial risk of forfeiture is not easy, but in general, Section 409A will not apply where the recipient must be employed on the date of payment.

If, however, an employee is entitled to payment, for example, as long as he was employed on Dec. 31, the payment is an exempt short-term deferral only if the payment is made by the following March 15.

If there is a possibility that the payment could be made after that date (such as when the audited financial statements become available), the exception will not apply even if payment is in fact made within the two-and-a-half-month short-term deferral period.

Specifying the bonus payment date in an agreement is therefore critical to ensure that the short-term deferral exception applies.

Releases of claims

Section 409A poses a hidden threat in agreements that provide for the payment of severance or other compensation made in exchange for a release of claims. Although this issue is not directly addressed in the statute or implementing regulations, the IRS views a release contingency as affording the employee the ability to shift payments between years.

That creates a potential Section 409A problem, even if the payment, absent the release requirement, would be exempt from Section 409A. An agreement must therefore designate in advance a maximum period of time to return the release and specify when payments will begin.

The IRS has approved three methods for satisfying those requirements, but other methods are available to the knowledgeable drafter, provided that they satisfy other applicable federal requirements such as the mandatory consideration and revocation periods set forth in the Age Discrimination in Employment Act.

When does a termination occur?

Because the obligation to make certain payments is typically triggered by or measured from the actual date of termination of the employment relationship (per Section 409A, a "separation from service"), determining the correct date on which the separation from service occurs is crucial to analyzing the application of Section 409A.

If the employer makes any payments too early (that is, before a Section 409A separation has actually occurred) or too late (that is, too far beyond the date specified in the agreement), the adverse consequences of Section 409A will apply.

The regulations contain a general rule that a reduction in working pace to 20 percent or less of the prior 36-month average will be treated as a separation, while continuing to work at a pace of 50 percent or more will not.

That general rule does not cover nearly all the complex termination scenarios typically negotiated by employment lawyers. For example, the common practice of terminating employment and continuing to provide "consulting services" for some period of time can run afoul of Section 409A.

In addition, special employer aggregation rules apply in determining whether a separation has occurred for transfers within the group.

Good reason resignations

Severance payments that are triggered by a resignation for "good reason" can be structured to be exempt from Section 409A under either the short-term deferral exception discussed above or within a useful Section 409A exception that applies to certain appropriately drafted separation pay plans.

The separation pay plan exception applies to payments made only upon an involuntary separation from service (including a resignation for good reason) that are paid by the last day of the second taxable year following the year of separation, provided the amount paid does not exceed two times the lesser of the annual rate of pay or a specified dollar limit (currently $530,000).

Both the short-term deferral and the separation pay plan exceptions are only available for a quit for good reason if the "good reasons" are themselves Section 409A compliant. A mere change in title, for example, is not sufficient.

Separation arrangements that do not qualify for one of the exceptions may still comply with Section 409A, but informed drafting and careful operation of the plan is required to be certain that they do.

Mitigating cash flow problems

A well-known provision of Section 409A requires certain employees of public companies to wait six months before a deferred compensation payment triggered by separation may be made.

That requirement can deprive a terminated employee with critical cash flow during a particularly stressful time. The cash flow problem may be mitigated by "stacking" the short-term deferral and the separation pay plan exceptions. Being able to take advantage of one or both exceptions, however, requires careful drafting and taking advantage of the limited flexibility that Section 409A provides to designate how payments (particularly installment payments) will be treated.

But this raises another classic Section 409A problem: the limited ability the law provides to modify a deal that is already in place.

Severance provisions are frequently negotiated and signed at the start of the employment relationship. It is not uncommon that, years later, when a separation is occurring, the parties may decide that the original severance deal is no longer appropriate. Yet, the regulations contain a broad anti-substitution rule that can cause disastrous consequences when an existing agreement is subjected to even minor tweaks.

One way to avoid that consequence is to have employers articulate and memorialize their usual practices regarding separation pay in a formal severance plan. Such an approach can provide significant benefits by standardizing severance arrangements for similarly situated employees, ensuring Section 409A compliance in form and practice, and reducing the need to separately negotiate severance deals.

A similar approach can be taken with respect to change in control payment arrangements.

Change in control arrangements

Transaction-based payments (including phantom stock and similar arrangements designed to provide service providers with the economic equivalent of some or all of what a shareholder would receive upon the sale of a business) often create Section 409A problems, particularly if a retention incentive is built in, or payments are intended to be delayed on account of earnouts or escrow arrangements that arise as part of the change in control.

In general, payments that are made as a result of the transaction will be compliant with Section 409A, provided the payment is triggered by a Section 409A-compliant definition of change in control.

Careful drafting also may allow payments to be exempt from Section 409A as a short-term deferral. But delaying payments otherwise required to be made on or shortly after the transaction date can create problems.

When amounts may be delayed due to an escrow, for example, the possibility that the payment would be made after the short-term deferral period can cause the payment to no longer qualify for the exception, and the delay may mean that the payment was not timely made.

The regulations do provide some flexibility for delayed payments in certain circumstances.

Payment flexibility

As noted above, Section 409A generally does not permit the timing and form of payments to be changed once they are established. For that reason, attorneys wishing to provide some flexibility on payment timing must anticipate and provide for this at the time the agreement is drafted.

For example, hardwiring a payment date or specifying the year in which the payment will be made allows the payment to be made later in the year without violating Section 409A, even if the payment is otherwise intended to satisfy the short term deferral exception.

On that same theme, although Section 409A generally prohibits delaying payments after the designated payment date, special exceptions permit "redeferrals" provided (among other requirements) that the payment is made at least five years after the original payment date.

It is generally not possible to redefer only part of a payment, and employees do not always find the redeferral exception to be useful. Where payments are made in installments, however, a special rule permits additional flexibility but only if the drafter took that into account when the arrangement was put in place.

Conclusion

While most practitioners understand the basic rules of Section 409A, as always the devil is in the many fine details of the law. We have reviewed only a handful of agreements over the years since the Section 409A regulations were finalized that did not require some modification to avoid potentially disastrous Section 409A consequences.

While the IRS has made correction programs available, those programs are of limited applicability and are best avoided whenever possible.

The stakes are high for counsel to either master or seek advice when drafting employment-related compensation provisions, lest they fall prey to the many pitfalls lurking in this law.

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David A. Guadagnoli and Amy E. Sheridan are partners in the tax department at Sullivan & Worcester in Boston.

Published: Wed, Apr 22, 2015

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