The IRS continues to provide both formal and informal guidance on the application of Internal Revenue Code Section 409A (“Section 409A”). Failure to comply with Section 409A creates serious and expensive tax issues. Below is a list of some common Section 409A errors.
When an executive is terminated, a company may seek to negotiate severance payments that are structured differently than the severance payments in the executive’s employment agreement. If severance payments are subject to Section 409A, then generally the time and form of payment cannot be changed merely by forfeiting or relinquishing rights under an old agreement for payments under a new agreement. This is considered a substitution payment under Section 409A and a substitution payment must retain the same time and form of payment as contained in the original agreement.
Similarly, an executive may have an employment agreement with severance payments subject to Section 409A and, at a later date, the company will decide to enter into a change-in-control agreement with the executive. If the new change-in-control agreement would alter the time or form of payment that was promised in the employment agreement, then the new agreement may be a substitution payment that violates Section 409A.
Separation from Service/Consultant
A termination of employment occurs under Section 409A when the employer and employee reasonably anticipate that no further service will be performed for the company (or its parent or subsidiaries) after a certain date, or that the level of bona fide services to be performed after that date (either as an employee or independent contractor) will decrease to 20% or less of the bona fide services performed by the employee on average over the prior 36-month period. When a key employee retires, the company may desire to retain the executive to provide consulting services as an independent contractor. However, under Section 409A, services as a consultant count when determining whether there has been a termination of employment. If the company retains the executive to provide consulting services at a rate of 50% of the services she provided as an employee, then she is deemed to have not terminated employment with the company for purposes of Section 409A. That means any payments under a nonqualified deferred compensation plan that were to commence at termination of employment cannot begin until the executive has a true termination of employment for purposes of Section 409A.
Short-Term Deferral Exception
In general, if an agreement states that payment will be made immediately upon vesting of an award — that award is exempt from Section 409A under the short-term deferral rule. For example, the award may require the employee to be employed with the company on the last day of a three-year performance period in order to receive payment, and payment is made within 30 days of the end of the performance period. That arrangement meets the short-term deferral rule. However, some long-term bonus plans and restricted stock unit plans contain early vesting provisions for “retirement.” Usually, these agreements will state that if the employee meets certain age and service requirements, then the employee can terminate at any time and receive either a pro rated or full bonus or award. Because this bonus or award is “vested” once the employee satisfies the age and service criteria, but payment may be made in a subsequent tax year after vesting (i.e., termination of employment or end of the performance period) — these awards or bonuses are not short-term deferrals and are not exempt from Section 409A. Because the company mistakenly thought the plan was exempt from Section 409A, the plan likely fails to include the required Section 409A language creating a documentary violation under Section 409A.
Section 409A generally provides that compensation for services performed during a taxable year may be deferred at the employee’s election if the election to defer such compensation is made not later than the close of the taxable year preceding the year in which the services are rendered. However, sometimes employers mistakenly allow employees to defer a discretionary bonus into a deferred compensation plan in the year before it is paid — rather than the year before it was earned. For example, an employer announces in 2010 that it will be awarding discretionary bonuses for services performed in 2011, and will decide which employees will receive bonuses and in what amounts at the beginning of 2012. In this example, the election to defer the discretionary bonus must occur no later than December 31, 2010 (the taxable year immediately preceding the year before it is earned) — not December 31, 2011 (the taxable year immediately preceding the year before it is paid).
Past Service Elections
Some deferred compensation plans use years of service in calculating the benefit formula. For example, upon termination of employment the employee will receive $10,000 for each year of service with the company. As discussed above, generally an employee must make elections regarding the time and form of payment before the employee performs the services upon which the benefit is based. For that reason, when past services are used to calculate the benefits and the employee is immediately vested in the plan benefit as of the day he becomes a participant in the plan, then it could be a violation of Section 409A for the employee to make an election as to the time and form of payment under the plan because the election would apply to services already performed. Instead, the plan must specify the time and form of payment. Section 409A contains a few exceptions to work around this predicament. One such exception permits an employee to make elections regarding the time and form of payment for a benefit that includes past services if the elections are made within the first 30 days of the date the employee becomes a participant and the benefit will not vest for at least 12 months after the 30-day election period. Companies should carefully review any benefit in a nonqualified deferred compensation plan that includes credit for past services to ensure it complies with the general election rule or the exception for benefits that vest over time.
Payment Upon Death
Under Section 409A, death is a permissible payment date. However, some deferred compensation plans state that payment will be made within a specified period after the plan receives notice or evidence of the death. Notice or evidence of death is not a permissible payment event under Section 409A. Accordingly, a provision that states, “the Company shall pay to the participant’s beneficiary a death benefit equal to the amount of the participant’s account in a single lump sum following receipt of notice of the participant’s death” would not comply with Section 409A.
The ability to offset payments from a nonqualified deferred compensation plan based on other benefits or debts owed to the company is highly restricted under Section 409A. Common errors include offsetting the amount of one deferred compensation plan from another deferred compensation plan. This type of offset can work if designed so that payments under both deferred compensation plans commence at the same time and are paid in the same form — which is not usually the case.
If a deferred compensation plan payment is contingent on the execution and irrevocability of a general release, the plan must state that the benefit will be payable either (a) on a specific date — such as on the 60th day after separation from service or (b) during a designated period not longer than 90 days after separation from service, but if the designated period begins in one taxable year and ends in a second taxable year, then the payment must be made in the second taxable year. For example, if benefits under a separation agreement are subject to Section 409A and the agreement states simply that the payment will be made within 60 days of separation of service, contingent on the execution of a general release, then the agreement likely fails to comply with Section 409A.
Bad “Good Reason” Definition
Severance plans drafted to be exempt from Section 409A generally rely on either the short-term deferral exemption or the separation pay plan exemption, or both. To meet these exemptions, these severance plans are drafted so that payment is dependent on the employee’s involuntary termination of employment. The severance plan may also permit payment upon the employee’s voluntary termination for “good reason.” However, sometimes this definition of “good reason” fails to meet the requirements of Section 409A (a bad “good reason” definition) and inadvertently the company fails the applicable Section 409A exemptions. For example, if a plan’s definition of good reason does not contain a notice and cure period, then termination for good reason under that plan will not meet the requirements of the short-term deferral or separation pay plan exemptions. Unfortunately, if the company believed that the exemptions applied, but the plan has a bad definition of good reason, then the plan was probably not drafted to alternatively comply with the Section 409A plan document requirements. The Section 409A regulations have a safe harbor definition for good reason. Therefore, best practice would to use the safe harbor definition and avoid a plan failure caused by a bad “good reason” definition.
Definition of Compensation for Elective Deferrals
Elective deferred compensation plans often specifically define what compensation a participant can defer under the plan. Sometimes, however, the plan document and the actual operation of the plan do not match — causing a Section 409A operational violation. For example, the deferred compensation plan may state that the amount deferred is calculated based on compensation paid before any deferrals to the company’s 401(k) plan. To the contrary, when the company’s payroll department implements the deferral election, it calculates the deferrals based on compensation paid after the applicable 401(k) deferrals. This creates an operational violation under Section 409A because too little has been deferred to the deferred compensation plan.
We suggest that you carefully review the plan documents and operational aspects of any benefits subject to Section 409A. If you have any questions about the contents of this article, please contact Mary Powell or Marc Fosse.