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Section 409A of the tax code establishes a comprehensive regime for the regulation of nonqualified deferred compensation and provides rules for the timing of initial deferral elections and subsequent deferral elections, the timing and form of distributions and the prohibition on acceleration of distributions.
On April 10, 2007, the IRS issued its
final Section 409A regulations, and on Oct. 22, 2007, the IRS issued
Notice 2007-86. Under the final regulations and this Notice, the IRS required that nonqualified deferred compensation arrangements operate during 2008 in accordance with the requirements of the final regulations or its prior
Notice 2005-1. In addition, the IRS required that the governing documents be amended by Dec. 31, 2008 to satisfy the final regulations.
Under the final regulations, a deferral of compensation occurs when an employee has a legally binding right in one year to compensation that is or may be payable in a later year. Moreover, a legally binding right exists when the employee has a right to the compensation even though the compensation is subject to a substantial risk of forfeiture. Thus, an employee can have a legally binding right to compensation before the employee vests in it.
Since a nonqualified plan of deferred compensation is broadly defined, Section 409A can apply to a broad array of arrangements: individual employment agreements, bonus plans, supplemental executive retirement plans, equity compensation plans, and severance arrangements. The severance arrangement can be part of an individual employment agreement, or a severance plan that applies to a broad group of employees or a specified group of employees, such as the employer’s senior executive officers.
If an arrangement’s governing document does not satisfy the requirements of Section 409A or an exemption thereto, or the arrangement’s operation does not satisfy these requirements, the tax consequences are as follows:
For example, assume that under the facts of the prior example:
For the employer, it is in its withholding obligation that, from the government’s perspective, the employer has skin in the Section 409A game, and from the employer’s perspective, its ox can be gored by the Section 409A ogre. When the employee recognizes income, the employer must withhold on the income recognized. The employer’s withholding obligation does not apply to the additional 20 percent tax, nor to the interest.
Under the facts of the current example, the employer must withhold regular income tax on the $30,000 in 2009, the year in which the violation occurs and the employee recognizes income. Since the Section 409A rules do not affect FICA withholding, the employer withholds FICA on deferred compensation in accordance with the rules of tax code Section 3121(a) or 3121(v)(2).
The final regulations classify severance arrangements as those not treated as deferred compensation, and those treated as deferred compensation:
For arrangements treated as deferred compensation, the governing documents must provide that the employer shall make payments at the time of separation from service, or on a specified date or fixed schedule set forth in the governing documents. In addition, for a group of employees of publicly traded corporations known as specified employees, the governing documents must require that the employer delay payment until six months after the date of separation from service.
The advantage of an arrangement not treated as deferred compensation, and therefore exempt from Section 409A, is that the arrangement is not subject to the six-month delay requirement.
Arrangements Not Treated as Deferred Compensation
Involuntary separation. A severance arrangement that provides for payments on involuntary separation from service, or pursuant to a window program, is not deferred compensation when the payments do not exceed two times the
lesser of (a) the sum of the employee’s annualized compensation based on the annual rate of pay for the calendar year preceding the year in which the employee separates from service (adjusted for any increase during that year that was expected to continue indefinitely had the employee not separated); and (b) the maximum permissible compensation taken into account under a qualified retirement plan for the year of separation.
For 2008, the maximum compensation is $230,000. In addition, the governing document must provide that the payments must be made by the last day of the second calendar year following the year of separation.
Collectively bargained plans. A collectively bargained severance plan is not deferred compensation when the plan provides for severance pay on an involuntary separation from service, or pursuant to a window program. A collectively bargained plan must be contained in an agreement that the U.S. Secretary of Labor determines to be a collective bargaining agreement; the severance pay was the subject of arm’s length negotiations between employee representatives and one or more employers; and the circumstances surrounding the agreement evidenced good faith bargaining between adverse parties over severance pay.
Window programs. A window program is a program established by the employer as part of an impending separation from service to provide severance pay, where the employer makes the program available for no longer than 12 months to employees who separate during this period, or to employees who separate during this period and satisfy the program’s requirements.
A window program that provides for severance pay on a voluntary separation from service is not deferred compensation.
Short-term deferrals. There is no deferred compensation when the employer completes the severance payments by the
later of (a) the 15th day of the third month following the end of the calendar year in which the right to the payment is no longer subject to a substantial risk of forfeiture; and (b) the 15th day of the third month following the end of the employer’s taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture.
A payment is subject to a substantial risk of forfeiture if entitlement to the payment is conditioned on the employee’s performance of substantial future services or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. If an employee’s entitlement is conditioned on his or her involuntary separation without cause, the entitlement is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
Accordingly, if a severance arrangement provides for payments on an involuntary separation, and the employer completes the payments within the short-term deferral payment period, the payments are a short-term deferral and not deferred compensation.
The short-term deferral exemption for payments on an involuntary separation applies to severance arrangements entered into at the commencement of employment, such as in an employment agreement, during the term of employment, and ad hoc arrangements entered into at the time of separation. For voluntary separations, such as an employee’s resignation, and separations pursuant to mutual agreement, the short-term deferral exemption applies only to ad hoc arrangements entered into at the time of separation.
If the parties previously entered into a severance arrangement at the commencement of employment or during the term of employment, any ad hoc arrangement entered into at the time of separation cannot accelerate or further defer the severance payments provided in the previous arrangements.
A major drawback to the employer of this exemption is that its limited payment period limits the effectiveness of any clawback of payments for the employee’s violation of his or her postseparation noncompetition, nonsolicitation, and confidentiality obligations. One way to accommodate the employee’s needs for funds during the short-term deferral period and to avoid the six-month delay requirement, and the employer’s need for a meaningful clawback right, is to provide for payments for six months after the date of separation that satisfy the exemption for payments on an involuntary separation, and to continue payments thereafter in the amounts the parties agree upon for the remaining term of the clawback period.
Definition of involuntary separation. The exemptions for involuntary separation, collectively bargained plans and short-term deferrals require an involuntary separation from service. The final regulations define an involuntary separation from service as a separation because of the independent exercise of the employer’s unilateral authority to terminate the employee’s services, other than at the employee’s implicit or explicit request, and when the employee was willing and able to continue performing services.
An involuntary separation includes the employer’s failure to renew an employment agreement when it expires, provided that the employee was willing and able to execute a new agreement with provisions substantially similar to those in the expiring agreement and to continue to provide services. The parties’ characterization of the separation as voluntary or involuntary in the governing document is presumed to be correct. This presumption may be rebutted by the facts and circumstances.
The regulations also treat an employee’s resignation for good reason as an involuntary separation. The governing document must define good reason to require actions taken by the employer resulting in a material negative change to the employee’s services, such as the duties performed, the conditions under which the duties are performed, and compensation. Other factors are the extent to which the severance payments on a resignation for good reason are the same amount as, and are to be made at the same time as payments on an involuntary separation, and whether the employee must give the employer notice of the condition constituting good reason and a reasonable opportunity to cure it.
The regulations provide a safe harbor definition of good reason:
Stock options. The parties often provide in severance arrangements for accelerated vesting and extension of the exercise period of stock options. The final regulations generally treat nonqualified options for the employer’s common stock that are issued with an exercise price equal to or greater than the stock’s fair market value on the date of grant as exempt from Section 409A.
The parties can accelerate the time for vesting of nonqualified options, which is the time the employee can first exercise the option. In addition, the parties can extend the exercise period to a date no later than the
earlier of the latest date on which the option would have expired by its original terms, and the tenth anniversary of the original date of the option grant.
Incentive stock options are also exempt from Section 409A. The rules governing incentive stock options permit accelerated vesting. If the parties agree to extend the exercise period for more than three months after the date of separation, incentive stock options become nonqualified options, and the rules for the permissible extension of the exercise period for nonqualified options apply.
The conversion from incentive stock options to nonqualified options is also important because the employer does not have an income and FICA tax withholding obligation on the exercise of an incentive stock option, but does have this obligation on the exercise of a nonqualified option.
Welfare benefits. For welfare benefits that are excluded from an employee’s income, the employer’s continuation of the benefits is not deferred compensation.
Legal settlements. The final regulations provide that to the extent an agreement provides for amounts paid for settlements or awards resolving bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, workers’ compensation statutes, and claim-related attorney’s fees, the agreement is not deferred compensation. Whether the employee’s waiver of a portion or all of the claims shows that the amounts are paid as an award or settlement of an actual bona fide claim for damages is determined by the facts and circumstances.
This exemption does not apply to the payment of amounts that do not result from an actual bona fide claim for damages. Thus, this exemption does not apply to amounts that would have been deferred or paid regardless of the existence of a claim, even if the amounts are paid or modified as part of a settlement or award resolving an actual bona fide claim.
Under these rules, severance arrangements entered into prior to the existence of a bona fide claim, such as those contained in individual employment agreements, or in broad-based severance plans, do not come within this exemption. Rather, these arrangements must come within another exemption, or satisfy the requirements of Section 409A.
In addition, for the parties to use the legal settlement exemption, there needs to be a sufficient amount of evidence to support the existence of a bona fide legal claim attributable to wrongful conduct. When the parties are negotiating a severance arrangement, especially prior to the institution of litigation, they often focus on reaching an expeditious resolution of the separation, rather than developing evidence of wrongful conduct. Accordingly, prior to the institution of litigation the parties may wish to rely on an exemption other than the legal settlement exemption, or satisfy the requirements of Section 409A.
Execution of release. An important issue is whether the employer can condition its payment of severance on the employee’s execution of a release. This condition raises the issue of whether the severance is paid on a separation from service, or on execution of a release. The involuntary separation, collectively bargained plan, and short-term deferral exemptions require an involuntary separation, which the regulations define as the independent exercise of the employer’s unilateral authority to terminate the employee’s services. The regulations do not address the role of the employee’s execution of a release in defining a separation from service.
One approach is to require the employee to execute a release within 30 days after the date of separation, and to commence payment of severance 45 days after the date of separation. In this manner, the employer can take the position that its payment of severance is not conditioned on the execution of a release for Section 409A purposes. But if the employee does not execute the release, the employee commits a material breach that relieves the employer of its obligation to pay severance. The regulations permit forfeiture by the employee as long as the forfeiture does not result in the employer’s payment of an amount as a substitute for other deferred compensation.
Finally, since the exemption for window programs provides that the employees must satisfy the program’s requirements, the employer can take the position that it can provide for the employee’s execution of a release as a requirement of the program.
Arrangements Treated as Deferred Compensation
Timing of payments. The severance arrangement must provide that the employer shall make severance payments on separation from service, or on a specified date or pursuant to a fixed schedule following the separation set forth in the governing document.
The employer must make a payment on separation from service either on the date of the separation, or a designated date following the date of separation that is objectively determinable and nondiscretionary at the time separation occurs. Alternatively, the employer can make the payment on a later date within the same calendar year as the date of separation or the designated date, or if later by the fifteenth day of the third calendar month following the date of separation or the designated date.
Amounts are payable on a specified date or pursuant to a fixed schedule if objectively determinable amounts are payable on a date or dates that are nondiscretionary and objectively determinable at the time the parties enter into the severance arrangement. An amount is objectively determinable if the amount is specifically identified, or if the amount can be determined at the time the payment is due pursuant to an objective, nondiscretionary formula specified at the time the parties enter into the arrangement.
Six-month delay for specified employees. For employees who are specified employees as of the date of separation of service, the employer cannot commence payment until six months after the date of separation, or if earlier the date of the specified employee’s death. There are two methods for satisfying this requirement:
Definition of specified employee. A specified employee means an employee who, as of the date of his or her separation, is a key employee of an employer any stock of which is publicly traded on an established securities market. A key employee is an officer with a minimum level of compensation at any time during the 12-month period ending on the specified employee identification date.
For a specified employee identification date of Dec. 31, 2007, the minimum compensation is $145,000. No more than 50 employees, or if less, the greater of three employees or 10 percent of the employees, are treated as officers.
The determination of the number of officers is made on a controlled group basis. When there are more than 50 officers, the 50 officers are determined from those who have the largest annual compensation.
The key employee determination is made during the 12-month period ending on a specified employee identification date. If an employee is a key employee as of a specified employee identification date, the employee is treated as a key employee for the 12-month period beginning on the specified employee effective date. Generally, the specified employee identification date is Dec. 31, and the specified employee effective date is the following April 1.
Execution of release. The prior discussion on whether the employer can condition its payment of severance on the employee’s execution of a release also applies to arrangements subject to Section 409A. In addition, the regulations provide that an amount is not objectively determinable if the amount of the payment is based all or in part on the occurrence of an event. The IRS can take the position that execution of a release is the occurrence of an event that does not permit distribution.
Steven H. Sholk, Esq., is an attorney with
Gibbons P.C. in Newark, N.J., where his practice includes employee benefits; employment and severance agreements; executive compensation; investments by tax-exempt benefit plans; tax-exempt financing; and tax-exempt organizations. He was elected a director of the firm in January 2008.
© 2008 Steven H. Sholk. All rights reserved.This article is posted with permission.
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