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Broad Definition Creates Potential Pitfalls for Employers

September 20, 2007
Related Topics: Finance/Taxes, Compensation Design and Communication, Miscellaneous Legal Issues, Featured Article, Benefits
Voluminous final Treasury regulations were issued April 10 under Section 409A of the Internal Revenue Code.

The section governs nonqualified deferred compensation arrangements—a term that is broad in its reach. In addition to regulating traditional executive compensation and equity compensation arrangements, Section 409A also regulates compensation devices that many employers have not typically considered as deferred compensation. These include severance arrangements, severance plans, deferred payments under employment agreements, annual bonus payments, long-term incentive arrangements, stay bonuses, and settlement agreements upon a termination of employment.

The rules under Section 409A are effective for compensation that was deferred or became vested after January 1, 2005. Because of the many ambiguities contained in these rules, good-faith operational compliance is permitted until the final regulations become effective on January 1, 2008.

The regulations originally required arrangements subject to Section 409A that were not in compliance with the rules to be amended by December 31, 2007. The IRS has announced a one-year extension for brining documents into compliance. The new deadline is December 31, 2008. But the extension only applies to the documentation of compliance under 409A—not the effective date of the new regulations. That is still January 1, 2008. The penalty for noncompliance is a 20 percent additional tax (imposed on the employee) on the amount of deferred compensation, which includes income plus interest. Further, employers may be subject to withholding and reporting tax penalties.

What does Section 409A require?
Under Section 409A, any arrangement that provides for the payment of compensation in a year later than the year in which the compensation was earned may be considered a deferred compensation arrangement. The section requires that companies have in place:

  • Form and timing of plan distributions: A deferred compensation arrangement must provide, at the time the arrangement is established, the form of the distributions to be made (e.g., lump sum or installments) and the timing of distributions. Distributions may commence at a fixed date or upon an employee’s separation from service, death, disability, change of control or unforeseeable emergency.
  • Deferral elections: An employee election to defer compensation must meet certain requirements. It generally must be made in the calendar year before the calendar year when the compensation is earned. However, special deferral timing rules relate to an employee’s initial eligibility to participate as well as deferrals of performance-based compensation.
  • Exception for performance-based compensation: If compensation is earned during a period of at least 12 months and can be classified as "performance-based" (certain bonus plans may fall within this category), an initial deferral election may be made as late as six months before the end of the measurement period. Compensation will be performance-based if it is contingent on the satisfaction of organizational or individual performance criteria, and if the performance criteria is not substantially certain to be met at the time of the deferral.
  • Exception for first year of plan eligibility: When an individual first becomes eligible to participate in a deferred compensation plan, a deferral election may be made within 30 days of their eligibility date and may apply only to compensation that is earned after the election date.
  • Subsequent deferral elections: Often plans that permit participants to defer compensation allow distributions to commence at a fixed point (or points) in the future, chosen by the participants. Although historically not sanctioned by the IRS, deferred compensation plan sponsors had relied upon court rulings to permit participants to revise this election.

Section 409A sanctions subsequent deferral elections provided that any such election becomes effective no earlier than 12 months after it is made, and that the new distribution commencement date is at least five years later than the original distribution date. If the initial election was to defer a distribution until a specific date (as opposed to an event, such as termination of employment), the subsequent election must be made at least 12 months before the first scheduled distribution.

  • Special rules regarding specified employees: "Specified employees" of publicly traded companies who trigger a payment of deferred compensation on account of their separation from service can’t receive deferred compensation until six months after their separation date.

The Section 409A rules do not apply to certain plans, including:

— Plans qualified under code Section 401(a), such as 401(k) plans.

— Annuity plans under Section 403(a).

— SEP or SIMPLE IRA plans under Sections 408(k) or (p).

— Bona fide vacation, sick leave, compensatory time, disability or death benefit plans.

— Annuity contracts of educational institutions, churches and tax-exempt charitable organizations under Section 403(b).

— Eligible deferred compensation plans of governmental employers and tax-exempt organizations under Section 457(b).

Guidance contained in the final regulations
Issues can arise with respect to determining whether an employee who terminates employment and either continues to work as a part-time employee or independent contractor is separated from service. The proposed regulations require that both compensation and service before and after the termination be compared.

The final regulations clarify that a separation from service will be presumed to occur when there has been a termination of employment and any subsequent service by the individual, as either an employee or independent contractor, does not exceed 20 percent of the service performed during the past 36 months. Conversely, there is a presumption that no separation has occurred if the level of continued service is 50 percent or more.

The final regulations provide additional flexibility by permitting an employer to designate, at the time compensation is initially deferred, that a specific percentage of service between 20 percent and 50 percent shall serve as an alternative threshold percentage.

However, employers should note that these rules are merely presumptions. For example, continued full salary and benefits could lead to a finding that there has been no separation from service even if the service level alone would create the presumption that there was a separation.

Short-term deferrals: Short-term deferrals are payments of compensation that are not considered deferred compensation because they are paid out by the 15th day of the third month following the tax year the payments became vested.

The final regulations broaden the use of this rule by permitting an employer to designate a series of payments as separate payments. This permits the first payment or payments to be made during the short-term deferral period, with others paid out as subsequent installments. This may be helpful with respect to specified employees who must otherwise wait six months to receive deferred compensation.

Employers may be able to designate a series of payments as "separate" to provide payments to "specified employees" during the short-term deferral period even though other payments may be subject to a six-month hold.

Severance pay exception: Section 409A exempts certain separation pay arrangements from 409A applicability if the payments are made upon an employee’s involuntary termination. In order to be exempted, the amount of the payments can be no more than the lesser of two times the annual pay or two times the Section 401(a)(17) limit ($450,000 for 2007). Further, all payments must be completed by the end of the second calendar year following the year of termination.

Proposed regulations provided an "all or nothing" approach to this exemption, whereby any amount that exceeded the dollar limitation would cause the entire amount to be outside the exemption. The final regulations discard this all-or-nothing approach and apply Section 409A only to amounts paid in excess of the limit.

This provision of the final regulations may facilitate a way around the six-month hold for specified employees for the first $450,000 of separation pay.

Involuntary termination: The final regulations also provide greater clarity with respect to what constitutes an "involuntary" termination.

"Good reason" terminations (where an employee leaves employment voluntarily after his or her employment is adversely affected) may be treated as an involuntary termination either under a "facts or circumstances" test or under a new safe harbor. Under the safe harbor, the good-reason termination must result from a material diminution in duties, pay, authority or a material change in job location. The safe harbor requires a 30-day cure period for the employer after the employee declares the existence of the good-reason condition. This declaration must be made within 90 days of the good-reason event. Because this safe harbor is a departure from contractual language generally found in employment agreements, it is not clear how many employers will utilize it.

This rule makes the drafting of employment agreements treacherous, as a faulty good reason could impose adverse consequences on an employee even though he or she is not ultimately leaving employment because of "good reason."

Where a termination is documented as a voluntary termination or a "mutual consent" termination, the final regulations provide that there will be a rebuttable presumption that the termination was voluntary. However, other evidence may overcome this presumption.

Settlement agreements: Under prior guidance, it was unclear whether payments made under a bona fide settlement agreement would be viewed as deferred compensation, especially if all or a portion of the payout was not in dispute.

The final regulations clarify that payments made in settlement of a bona fide dispute over the payment of deferred compensation will not cause a prohibited acceleration of deferred compensation to occur.

The regulations provide that the dispute must relate to the amount of the payment, not just when a payment is due. Additionally, the regulations prohibit the use of this exception unless an employee would receive substantially less without a settlement agreement.

Since many employers do not view settlement agreements as involving deferred compensation, this may be a pitfall that’s easy to stumble into.

Equity compensation provisions: Section 409A provides that stock compensation vehicles will be outside Section 409A’s reach if, among other things, an option or stock appreciation right (SAR) is issued on "service recipient stock." The proposed regulations had restricted this exemption to options or SARs issued on the highest class of stock, and if an affiliate-employer had publicly traded stock, such stock had to be used.

The final regulations broaden the definition of "service recipient stock" to include any class of stock and permit stock of an employer, parent or subsidiary to be used. However, the common stock used cannot have any preferences other than a liquidation preference.

In determining which corporations are in a parent-subsidiary chain, the regulations permit common 50 percent ownership (as opposed to 80 percent) to be used as the standard. A 20 percent threshold may be used if there is a legitimate business purpose.

The proposed regulations did not permit the post-termination extension of an option or SAR exercise period beyond the later of December 31 of the year of the original expiration date, or two and one-half months after the original expiration date (without causing the stock right to be subject to Section 409A). The final regulations permit certain extensions of the exercise period for in-the-money options or SARs so long as the extension is not beyond the original term of the option or SAR and not beyond 10 years from the grant date. An "underwater" option can also be extended.

Extreme caution is warranted when providing stock-based compensation to employees as a stock right may start off as exempt from these rules, but may become subject to the rules at a later date.

Plan termination: The proposed regulations provided that an employer could terminate all deferred compensation plans of the same type, and pay out all account balances without violating Section 409A if benefits were paid out between 12 and 24 months of termination and no similar plan was adopted within five years. The final regulations liberalize this rule by permitting a new plan after three years.

Since all plans of the same type must be terminated, final regulations further facilitate the ability of employers to terminate plans by creating nine different categories of deferred pay plans (as opposed to four categories under the proposed regulations).

Deadlines and action items
    December 31, 2008—documentary compliance deadline:
The regulations are effective January 1, 2008 and arrangements must be operated in accordance with these regulations at such time; prior to this date, arrangements must be operated in accordance with "good faith compliance" with the Section 409A rules. Documents governing such arrangements, however, need not be amended until December 31, 2008

. Noncompliant distribution provisions may be changed to provide 409A-compliant provisions so long as this does not cause amounts to be (1) deferred until a date later than December 31, 2007, if, in the absence of the amendment, payment would be made in 2007, or (2) accelerated into 2007 if the amount would otherwise be payable at a later date.

The final regulations permit employers to comply with Section 409A by using more than one document for a single plan or payment. Thus, an employer can adopt "umbrella" documents that amend all plans of the same type or category to comply with Section 409A. Note that if the umbrella document amends a deferred compensation plan or an employment agreement that requires employee consent, the document will be subject to the signature acceptance of each affected employee.

Action items for employers: There are several steps that employers should take to avoid the pitfalls contained in the Section 409A rules, including:

  • Create an inventory of all arrangements that contain "deferred compensation."

  • Determine which arrangements are subject to the Section 409A rules.

  • Ascertain whether arrangements are in current operational compliance.

  • Amend noncompliant arrangements by the end of 2008.

  • Consider adoption of "umbrella documents" in 2007, which will contain omnibus Section 409A language for all similar arrangements

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