Section 409A was added to the Internal Revenue Code in 2004, and the bulk of current detail and guidance explaining 409A became effective in 2008. Since that time, 409A has fallen out of the spotlight but remains an important issue, with many limitations and substantial penalties for non-compliance.
DO YOU HAVE ARRANGEMENTS AFFECTED BY 409A?
409A affects:
- employment agreements
- severance agreements
- bonus structures
- stock option plans
- stock appreciation rights
- phantom equity plans
- supplemental executive retirement plans (SERPs)
- consulting agreements
- director pay agreements
- any other plan that gives an employee or independent contractor a right in Year One to a payment that will (or might) occur in Year Two or later
WHAT HAPPENS IF 409A IS VIOLATED?
Current taxation plus interest and penalties plus 20% excise tax. For example, in Year One, Employee and Employer sign an agreement stating that Employer will pay Employee $100,000 in Year Five, but Employer may choose to pay Employee earlier than Year Five. Employee is paid in Year Five. The agreement violates 409A, and as a result the normal income tax is treated as having been due in Year One (rather than Year Five). In addition, a 20% excise tax is imposed. Employee will be liable for (a) full amount of regular income tax on the $100,000, PLUS (b) a $20,000 excise tax, PLUS (c) five-years worth of interest and penalties for late payment. Employer is responsible for withholding and reporting such amounts.
WHO IS SUBJECT TO THE 409A PENALTIES AND EXCISE TAX?
The employer is subject to withholding and reporting obligations, but the interest, penalties, and excise tax are imposed on the employee.
WHAT DOES 409A REQUIRE?
Once compensation is deferred, 409A says that the compensation:
- Can be paid only at certain times or when certain events occur (death, disability, change of control, separation from service, unforeseeable emergency, fixed time/schedule)
- Cannot be accelerated
- Cannot be deferred again except in limited situations
- Can be paid only in the form/manner initially specified in plan (e.g., lump sum v. installment)
HOW DO WE BEST DEAL WITH 409A?
Address 409A by:
- Finding an exception. 409A applies to “nonqualified deferred compensation.” If your arrangement falls under an exception to that term, 409A restrictions will not apply. OR
- Compliance. If no exceptions apply, your arrangement must comply with the detailed restrictions imposed by 409A. Compliance includes following the definitions included in 409A. For example, your compensation may be payable on “disability,” but either not defined in your arrangement, or defined in your arrangement differently than in 409A, causing a potential violation. Defining terms by reference to 409A does not typically work. (E.g., “…to be paid upon disability, as such term is defined in 409A” is insufficient.)
WHAT ARE THE MAJOR TRAPS AND PITFALLS OF 409A?
Nonqualified Deferred Compensation.
409A applies to “nonqualified deferred compensation,” which does not always match a person’s understanding of what gives rise to deferred compensation and is broader than one might suppose. For example, assume an agreement provides: “Employee shall earn a salary of $100,000 each year, to be paid $75,000 in bi-weekly installments throughout the year, and $25,000 two years after the year in which such amount was earned.” It seems clear that the $25,000 payment is deferred compensation. However, instead assume the following: “If 75% of the Company is sold to an Outside Party, Employee shall be paid $100,000 on the 90th day after such sale.” Some may assume this is not deferred compensation, because the employee will not be entitled to payment until the company is sold. However, 409A applies where someone receives a legally binding right to compensation in one year that is, or may be, payable in a later taxable year. 409A considers the employee to have a legally binding right at the present time (i.e., if the company is sold, employee is entitled to payment). The company may be sold in a later year, which means the employee may receive a payment in a later taxable year. The arrangement is subject to, and must comply with, 409A.
Definitions.
Even if deferred compensation is payable only under one or more of the six payment events specified in 409A, the definitions in the agreement must comply with 409A. Defining terms by reference to 409A is typically insufficient.
Catch-all Language.
Blanket language is not enough to avoid a 409A violation. For example, the following phrases would not result in 409A compliance: “…provided such payment complies with 409A.” “The Board shall have the sole discretion to amend any payment under this plan to comply with 409A.” “This plan is intended to and shall at all times comply with 409A.”
Key Employees.
Key employees of publicly traded companies must wait six months before receiving any separation payments subject to 409A. You must analyze which employees will be “key employees” under 409A. Fortunately, certain exceptions to 409A may allow for immediate payment of at least a portion of a key employee’s separation pay. This article generally addresses basic 409A issues and represents only the tip of the proverbial iceberg. Given the substantial penalties and complicated rules of the 409A regulations, careful analysis is advisable, to (i) ensure compliance with 409A, and (ii) provide the most flexibility within 409A to best meet the goals of a proposed compensation arrangement. \
IRS CIRCULAR 230 DISCLOSURE: To comply with IRS regulations, we advise you that any discussion of Federal tax issues in this communication was not intended or written to be used, and cannot be used by you, (i) to avoid any penalties imposed under the Internal Revenue Code, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.