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Executive Employment Agreements: Code §409A Checklist
Section 409A of the Internal Revenue Code (the Code), which became law Oct. 22, 2004, accelerates inclusion in ordinary income of certain forms of deferred compensation that fail to meet its requirements.
In doing so, it imposes, in addition to the ordinary income tax, an additional tax of 20 percent and, in addition to interest at the ordinary rate on the resulting underpayment, an additional interest charge of 1 percent. Final Regulations under Code §409A (the Regulations) took effect April 17, 2007 with compliance by deferred compensation plans subject to Code §409A generally required by Jan. 1, 2008. It is noted that there may be state tax implications as well.
For purposes of Code §409A, a deferred compensation plan is one that "provides for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the service provider in a later taxable year." A "plan" includes an employment agreement and a "service provider" includes an executive.
The purpose of this column is to provide readers a checklist of items of compensation and benefits that are typical to employment agreements and that may be subject to Code §409A. Except as incidental to identifying the checklist of potential Code §409A items, it is not intended to explain how the complex rules under Code §409A (the Regulations themselves cover approximately 400 pages) apply to the different types of compensation and benefits listed below.
Subject to Code
• Items, Typical to Employment Agreements, That May Be Subject to Code §409A
1. Sign-on Bonus. Frequently, the period between the date an executive is hired and the date payments are completed as to any sign-on bonus covers more than one taxable year. For example, a sign-on bonus might be paid 50 percent on date of hire and 50 percent on the first anniversary. If at date of hire an employment agreement gives the executive a legally binding right to payment in a future year, or years, the payment represents deferred compensation under Code §409A. Accordingly, unless the payments to be made in the year or years following the date of hire are subject to a substantial risk of forfeiture or, following the year in which they cease to be subject to a substantial risk of forfeiture they come within the 2-1/2 month "short-term deferral" exception of Treasury Regulation §1.409A-(1)(b)(4), these payments must comply with, among other provisions, the permissible distribution requirements of Code §409A(a)(2)(A), or they will be in violation of Code §409A.
2. Annual Bonus. As in the case of a sign-on bonus, if an annual bonus is earned in one taxable year and paid, in whole or in part, in another, attention must be given to its status as deferred compensation under Code §409A. It is not uncommon in the financial services industry, for example, to pay part of the annual bonus shortly after the close of the year in which the services were performed and to pay the rest in a later year. Assuming the first part (usually cash) is paid in the year the services are provided or within 2-1/2 months after the close of that year (pursuant to the "short-term deferral" rule), it should not be a problem under Code §409A. The second part, the deferred amount, often is in the form of an equity award (see discussion below of equity awards). As in the case of the sign-on bonus, if the deferred portion of the annual bonus is not subject to a substantial risk of forfeiture and is not within the time necessary for it to come within the short-term deferral exception, it must comply with, among other provisions, the permissible distribution requirements of Code §409A(a)(2)(A) to avoid a problem under that section.
3. Equity Awards. Stock options and stock appreciation rights are treated as deferred compensation that is excepted from Code §409A provided they meet certain requirements (e.g., a stock option must have an exercise price no less than market value of the stock on date of grant). Shares of restricted stock, being property, are not deferred compensation for purposes of Code §409A. Restricted stock units, which are not property but a promise to pay in the future, are deferred compensation that must comply with Code §409A. Other forms of equity awards (e.g., performance shares and phantom shares) should be examined carefully to determine whether their characteristics are those of deferred compensation. The application of the rules to equity plans and awards can be very complicated and careful attention must be given as to how the rules apply (or do not apply) to a particular form of equity award.
4. Other Long-Term Incentives. These include awards tied to performance over several years. They are like annual bonuses but are earned over a longer period. For purposes of Code §409A, the issue, like that for an annual bonus, is whether they are paid in a taxable year after the year in which they are earned. Even then, as noted earlier, exceptions may exclude application of Code §409A (e.g., the short-term deferral exception for an incentive award paid within 2-1/2 months after the year in which it is earned, i.e., becomes vested).
5. Pension Benefits. Tax-qualified pension plans are excluded by Code §409A(d)(1)-(2) from the status of nonqualified deferred compensation plans subject to Code §409A. On the other hand, supplemental pension benefits provided to executives by employment agreements (or by supplemental pension plans referenced in such agreements) are subject to the rules of Code §409A. These nonqualified pension plans must comply with, among other things, the requirements of Code §409A(a)(2) relating to the time when payment of benefits is to be made under the plans.
6. Welfare Benefits. Treasury Regulation §1.409A-1(a)(5) provides for exclusion from nonqualified deferred compensation plan status for a number of categories of welfare benefits. These include certain tax-qualified medical reimbursement arrangements and any "bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan." On the other hand, many types of welfare benefits under executive employment agreements may be nonqualified deferred compensation plans including executive medical plans, executive life insurance, etc. Of course, a welfare benefit plan that constitutes a nonqualified deferred compensation plan may avoid additional tax by complying with the requirements applicable under Code §409A to such a plan.
7. Perquisites and Expense Reimbursements. Treasury Regulation §1.409A-3(i)(1)(iv) provides rules with regard to expense reimbursement and "in-kind" benefit plans. For definition of "in-kind" benefits, see Treas. Reg. §1.409A-1(p). Perquisite and expense reimbursement plans, where there is a legally binding entitlement that goes beyond the taxable year in question, may be treated as nonqualified deferred compensation plans.
8. Terminations. In order to comply with Code §409A, a nonqualified deferred compensation plan (which, as noted, includes an employment agreement that contains items of deferred compensation) must provide that no distribution will be made prior to one of the distribution events or a specified time, or times, as provided in Code §409A(a)(2)(A)(i)-(vi). This requirement is subject to exceptions provided for a number of special circumstances in which acceleration is permitted without violating Code §409A. Paragraphs (a) through (f) below cover six different types of terminations of employment in which distributions are permitted under clauses (i) and (iii) of Code §409A(a)(2)(A).
It should be further noted that where an employment agreement provides for payments to be made to an executive upon a "separation from service," which is a permitted distribution event under Code §409A(a)(2)(A)(i), such payments, including severance payments, may have to be delayed pursuant to Code §409A(a)(2)(B)(i) for six months from the date of "separation," if the executive is a "specified employee." Severance payments, of course, are most likely to be paid in connection with a separation in the form of an involuntary termination without cause by the employer (which includes a termination qualifying as a termination for good reason under the Regulations; see further discussion as to good reason below). (A termination due to death is not subject to the six-month rule.)
For purposes of the six-month delay rule, a "specified employee" generally means a key employee who is an officer of a publicly traded company with annual compensation greater than $145,000 (as indexed currently). (Total number of key employee officers is limited to 50.) In determining whether the six-month delay rule applies in particular cases, it is important to determine not only whether the executive involved is a "specified employee," but also to determine whether any of the Treasury Regulation §1.409A-1(b)(9) exceptions, based on limitations as to amount and time, and other exceptions, as described above, apply.
Following are typical terminations covered by the termination provisions in the employment agreement:
a. Termination by the Employer Without Cause. A termination without cause is a "separation from service," the permissible distribution described in Code §409A(a)(2)(A)(i), and, generally speaking, should qualify for the exception for a portion of severance payments described in Treasury Regulation §1.409A-1(b)(9)(iii) (the exception is discussed in clause (i) of footnote 11 to this column) and the exception provided by the 2-1/2 month short-term deferral rule. If the executive is (or reasonably likely may become) a "specified employee," as noted above, specific provision should be made in the employment agreement that payments will be delayed to the extent delay is required under the six-month rule. The Regulations make clear that a general statement in an employment agreement that it is intended to comply with Code §409A will not satisfy this requirement.
b. Termination by the Employee for Good Reason. The Regulations permit treatment of a termination by the executive for a reason that constitutes "Good Reason" within the meaning of the Regulations to be treated as an involuntary termination. For purposes of this discussion, this means it will be treated the same as a termination by the employer without cause, as discussed in paragraph 8a, for purposes of the Code §409A requirements and the exceptions thereto. The Regulations state that the question of whether a Good Reason definition will be satisfactory for this purpose depends on the facts and circumstances. The Regulations do provide a "safe harbor" listing of a number of circumstances that may be included in a definition of Good Reason that will qualify under the Regulations. Care must be taken in drafting any provision that varies from the safe harbor definition of Good Reason. The risk, among other things, is loss of treatment as an involuntary termination and consequent loss of exception for a portion of severance payments (discussed in clause (i) of footnote 11) and the loss of exception provided by the 2-1/2 month "short-term deferral" rule.
c. Termination by the Employer for Cause. Ordinarily, the executive does not receive severance payments in the event of a termination for cause. The compensation and benefits that are received customarily are limited to those already earned and vested under applicable plans and other arrangements of the employer. The provisions of the applicable plans and other arrangements should be checked in this respect but it is unlikely that the employment agreement itself will cause issues under Code §409A in connection with a termination for Cause.
d. Voluntary Termination by Employee (Without Good Reason). Like a termination for cause, ordinarily a voluntary termination does not give rise to severance benefits and should not itself be a "red flag" problem under Code §409A in reviewing an employment agreement. If, however, provision were made for severance to be paid in connection with a voluntary termination without Good Reason (which would be a most unusual circumstance), severance would not qualify as severance pursuant to an involuntary termination - a point discussed in paragraph 8b above in connection with a failure of the definition of Good Reason to comply with the requirements of the Regulations. These risks include loss of exceptions noted in paragraph 8b.
e. Termination due to Disability. Payments upon termination of employment for disability are subject to the same requirements under Code §409A as discussed above in the case of payments made on account of any other form of "separation from service," including the need for the agreement to specify the time and method (i.e., lump-sum versus installments) for the payments and to provide for a delay in the payments under the six-month delay rule unless the payments qualify for one of the exceptions discussed above. However, if, as Code §409A(a)(2)(A) permits, the employment agreement provides for payments to be made upon the executive becoming disabled, as defined in Code §409A(a)(2)(C), instead of upon his later termination of employment, the six-month delay rule would not apply to the payments so made.
f. Death. Since death is a permissible event for payment of deferred compensation under Code §409A(a)(2)(A) and the six-month delay rule would not apply to the payments so made, the inclusion of a payment as a result of death should not itself result in any Code §409A issues. This assumes compliance with the requirements for the agreement to specify the time and method (i.e., lump sum versus installments) for the payment.
Change in Ownership
9. A Change in Ownership or Control as a Distribution Event. Code §409A(a)(2)(A)(v) provides that "to the extent provided by the Secretary, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation" constitutes a permissible distribution event. The Regulations go into much detail regarding the meaning of a change in ownership or control for purposes of Code §409A. Treas. Reg. §1.409A-3(i)(5).
Thus, an employment agreement can provide for automatic acceleration of payment of severance (or any other items of deferred compensation) upon the occurrence of a covered change in ownership or control, without violating the permissible distribution requirements or the six-month delay rule of Code §409A (because the payments are not made on account of a separation from service). However, some employment agreements, at least in the past, have provided that an executive may leave voluntarily (and without Good Reason) during a specified period of time following the change in ownership or control (e.g., the first six months) and receive the same severance upon such termination as he would if terminated without cause. For reasons discussed in paragraph 8 above, such a right on the part of an employee to terminate voluntarily and receive severance could result in loss of exceptions otherwise applicable to severance as noted in paragraph 8b above.
1. 26 USC §409A, added to the Code by §885 of the American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418.
2. 26 USC §409A(a)(1)(B).
3. The Regulations, entitled "Application of §409A to Nonqualified Deferred Compensation Plans," were issued April 10, 2007 and appeared in the Federal Register April 17, 2007. 72 Fed. Reg. 19234.
4. For example, the instructions to Form 540, the California Resident Income Tax Return, provide in reference to line 33 of the form, that "California conforms to federal law for income received under IRC §409A on a nonqualified deferred compensation plan." On this basis, a resident of California might end up with Federal and state income tax at an aggregate net effective rate in excess of 85 percent. This does not take into account employment taxes.
5. Treas. Reg. §1.409A-1(b)(1).
6. For definition of "Plan," see Treas. Reg. §1.409A-1(c). The concept of "plan" as covered by this Treasury Regulation includes many different types of compensation and benefit plans in which executives participate. These plans, which exist independently of an employment agreement, are not themselves the subject of the column. Some of these may be incorporated into the employment agreement, some may be referenced but not be identified, such as in a reference to welfare benefit plans generally, and some may not be referenced at all. Also outside the scope of the column are severance agreements. A severance agreement raises some issues that are different from those involved in an employment agreement (although there will be a good deal of overlap in items covered). For example, a severance agreement may result in cancellation of an existing entitlement in consideration for some other benefit to be provided by the severance agreement. Attention must be given in such a case to whether the IRS might take the position that the cancellation and substitution are, in fact, an acceleration of a benefit. See Treas. Reg. §1.409A-3(f). The issue then would be whether the "acceleration" violated the rules of Code §409A(a)(3).
7. For definition of "Service Provider," see Treas. Reg. §1.409A-1(f).
8. The permissible distributions as listed in Code §409A(a)(2)(A) cover a separation from service, disability, death, a specified time (or a fixed schedule), a change in control of a company or ownership of assets and the occurrence of an unforeseeable emergency. All of these terms are subject to definitions, in some cases in the statute (e.g., unforeseeable emergency and disability) and in some cases in the Regulations (with some of the definitions, such as change in control or ownership of assets, being quite elaborate).
9. Treas. Reg. §1.409A-1(b)(5)(i)(A)(1).
10. The Regulations provide five specific conditions that must be met for a "reimbursement" or "in-kind" plan to comply with Code §409A. Treas. Reg. §1.409A-3(i)(1)(iv). In addition to the requirement that there be an objectively determined nondiscretionary definition of expenses and in-kind benefits and provision that "the right to reimbursement and in-kind benefits not . . . [be] subject to liquidation or exchange for another benefit," Treasury Regulation §1.409A-3(i)(1)(iv)(A)(2)-(4) provides three timing/schedule requirements that must be satisfied in order to comply with the specific time or fixed schedule requirement of Code §409A(a)(2)(A)(iv). It should also be noted that in the case of certain reimbursements and other payments incurred in connection with separations that certain other requirements may be applicable, including the period of time in which expenses may be incurred or in-kind benefits may be provided following a separation from service. See Treas. Reg. §1.409A-1(b)(9)(v).
11. In connection with the discussion of different terminations typically covered in employment agreements, the following two points are noted:
(i) Certain severance arrangements, namely, those that provide for payment of severance only upon an involuntary termination of employment (i.e., a termination by the employer without Cause or, provided it meets the requirements of the Regulations, a termination by the executive for Good Reason (as discussed in paragraph 8(b) of the text), are excepted from status as nonqualified deferred compensation under Code §409A to the extent of that portion of the total amount of the severance payments that does not exceed the lesser of (x) two times the amount of annual compensation that can be taken into account under a tax qualified plan under Code §401(a)(17) (currently $225,000; $450,000 when multiplied by two) for the year of separation, and (y) the annual rate of pay for the executive at the time of separation provided that such portion of the total severance amount is paid not later than the end of the second taxable year following the year in which separation occurs. Treas. Reg. §1.409A-1(b)(9)(iii).
(ii) In addition to the exception for severance plans that meet the requirements noted in subparagraph (i) above, and for those that meet the conditions for the 2-1/2 month short-term deferral exception discussed above to apply, there are numerous other exceptions from nonqualified deferred compensation plan status for compensation and benefit arrangements that may be associated with separations. Treas. Reg. §1.409A-1(b)(9). The separation pay plans listed as excepted from deferred compensation status under Code §409A, provided they comply with the Regulations, include collectively bargained plans, a "window program" (for the definition of window program, see Treas. Reg. §1.409A-1(b)(9)(vi)), foreign separation payment plans, reimbursements of business expenses, specific tax-favored medical plans, certain in-kind and direct service benefits, indemnification plans and insurance policies protecting against certain liabilities, legal claim settlements in connection with employment-related claims, and certain educational benefits.
12. Treas. Reg. §1.409A-3(j)(4) lists special circumstances in which acceleration may be permissible.
13. Clause (ii) of Code §409A(a)(2)(A) permits distributions on the date when an executive becomes "disabled," as defined in §409A(a)(2)(C), whether or not the executive's employment terminates on that date, and clauses (iv) - (vi) of Code §409A(a)(2)(A) cover other circumstances that do not relate directly to a termination event; one of these other events, a change in ownership or control, is covered in paragraph 9 of the text.)
14. The statute defines a "specified employee" as a key employee (as defined in Code §416(i)) of a company whose stock is publicly traded on an established securities market. Code §409A(a)(2)(B)(i). Code §416(i) defines a key employee as an employee who is (i) an officer whose annual compensation is greater than an amount currently indexed for 2007 at $145,000, (ii) a 5 percent owner of the employer or (iii) a 1 percent owner of the employer with annual compensation of more than $150,000. The number of employees that can be included as "key employees" under category (i) (that is, as officers of the employer) is limited to a maximum of 50 employees. If the employee officers number less than 50, then the number within category (i) is limited to the greater of three such employees or 10 percent of all employees.
15. To the extent the six-month delay is required, employment agreements sometimes provide that the executive will be entitled to interest payments for the period of time that severance otherwise due the executive is delayed because of Code §409A. If an additional 20 percent tax is incurred due to the negligence of the employer, whether due to the failure to comply with the six-month rule or otherwise, the executive has a strong argument that he should be grossed up. This, of course, is an issue that an executive appropriately might raise in connection with the negotiation of an employment agreement.
16. Treas. Reg. §1.409A-1(n)(1)-(2).
17. Treas. Reg. §1.409A-1(n)(2)(ii).
18. Another potential problem for a voluntary termination without Good Reason would be a settlement payment accompanying the termination. The IRS might claim such a payment to be the result of an acceleration of vesting and payment of deferred compensation otherwise forfeitable upon a voluntary termination and thus a violation of the rules as to permissible accelerations under Code §409A. See Treas. Reg. §1.409A-1(b)(9)(i). This is more a problem at the time of separation than a problem of identifying issues currently involved in an employment agreement.
19. Two further, unrelated problems that might arise under Code §409A in connection with a change in ownership or control are as follows:
(i) A problem could arise under Code §409A in the event of an accelerated vesting of an award (not itself a problem) which is then deferred over more than one taxable year without distribution being tied to a schedule or event qualifying under Code §409A(a)(2)(A).
(ii) What happens if the employment agreement provides a gross-up of an excise tax under Code §§280G and 4999: could this constitute an impermissible distribution triggering an additional 20 percent tax under Code §409A? Treasury Regulation §1.409A-3(i)(1)(v) describes circumstances in which the tax gross-up will be treated as a permissible distribution. The employment agreement must provide that the gross-up will be paid by the end of the taxable year following the taxable year in which the executive pays the taxes to be grossed up; and the gross-up must, in fact, be made as provided in the employment agreement.