Beware of Section 409A Traps in Employment Agreements

By now, virtually all employers have addressed compliance with Internal Revenue Code section 409A (‘section 409A’) as it relates to their nonqualified deferred compensation plans, phantom equity plans, stock option plans (for closely held businesses), and stock appreciation rights.  However, it appears that some employers still may not have reviewed their executive employment agreements with respect to compliance with section 409A. 

As a reminder, failure to comply with section 409A results in expensive tax issues not for the employer, but for the executive, including income tax on any amounts deferred under the agreement retroactive to the first year the agreement violated section 409A, interest on the unpaid taxes, and an excise tax payable by the executive (not payable by the employer) of 20% of the income recognized.

We discuss below some of the more common section 409A compliance issues as they relate to employment agreements.

BONUSES

Many executive employment agreements contain provisions for bonuses both short-term (annual) and long-term.  In general, if an agreement states that the bonus payment will be made immediately upon vesting of an award, then the bonus is exempt from section 409A under the short-term deferral rule. Alternatively, the short-term deferral rule would also allow the agreement to state that the bonus earned will be paid as soon as administratively possible, but not later than March 15 of the year following the year in which the bonus was earned.  This gives the company (not the executive) some flexibility for making payment.  For example, the award may require the executive 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 arrangements contain early vesting provisions for retirement.  Generally, these agreements state that if the executive meets certain age and service requirements, then he can terminate at any time and receive either a pro-rated or full bonus or award. Since the bonus is vested once the executive satisfies the age and service criteria, but payment can or will be made in a subsequent tax year (i.e., termination of employment or end of the performance period), the bonus does not meet the short-term deferral rule and is not exempt from section 409A.  Because the company mistakenly believes that the agreement is exempt from section 409A, it likely fails to include the required section 409A language regarding the time of payment creating a document failure under section 409A. 

Bonus Deferral Elections 

Section 409A generally provides that compensation for services performed during a taxable year may be deferred at the executive’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, employers often mistakenly allow executives to defer a discretionary or incentive bonus into a future tax year in the year before it is paid rather than the year before it was earned.  For example, an executive earns an incentive bonus in 2012 that would otherwise be payable in 2013 and the employer allows him to defer payment until 2014 by written election in 2012.  In this example, the election to defer the bonus should have been executed no later than December 31, 2011 (the taxable year immediately preceding the year it is earned) and not December 31, 2012 (the taxable year immediately preceding the year it is paid).  Further, the employment agreement would need to be drafted to contain provisions providing for the deferral of the bonus and those provisions need to comply with section 409A.

SEPARATION FROM SERVICE

A termination of employment occurs under section 409A when the employer and executive reasonably anticipate that after a certain date no further service will be performed for the employer (or its parent or subsidiaries) or that the level of services to be performed after that date (either as an employee or independent contractor) will decrease to 20% or less of the services performed by the employee on average over the prior 36-month period. When an executive retires, the employer 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% or greater of the services he provided as an employee, then he is deemed to have not separated from service with the employer for purposes of section 409A.  That means any payments under an employment agreement or under a nonqualified deferred compensation plan that were to commence at termination of employment cannot begin until the executive has a true separation of service for purposes of section 409A.

Substitution Payments 

When an executive is terminated, an employer may seek to negotiate severance payments that are significantly different than the severance payments in the executive’s employment agreement. If the severance payments are subject to section 409A, then 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 will be 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 employer will decide to enter into a change-in-control agreement with the executive. If the provisions of the new change-in-control agreement 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.

General Release 

If a deferred payment under an employment agreement (typically severance or a bonus) is contingent on the execution and irrevocability of a general release, the agreement must state that the amount due 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 deferred payments under an employment 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.

“Good Reason” Definition 

Severance provisions under an employment agreement are that are 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 provisions are drafted so that payment is dependent on the employee’s involuntary termination of employment. A severance provision may also permit payment upon the executive’s voluntary termination for “good reason.” However, occasionally this definition of “good reason” fails to meet the requirements of section 409A and inadvertently fails to meet the applicable section 409A exemptions. For example, if an agreement’s definition of “good reason” does not contain a notice and cure period, then termination for good reason under that agreement will not meet the requirements of the short-term deferral or separation pay plan exemptions. Unfortunately, if the employer believes that the exemptions apply, but the agreement has a noncompliant definition of good reason, then it is probably not drafted to alternatively comply with the section 409A. The section 409A regulations have a safe harbor definition for good reason. Therefore, best practice would be to use the safe harbor definition and avoid a violation under section 409A.

PAYMENTS UPON DEATH

Some employment agreements provide for the payment of a death benefit or accelerate bonus or other payments upon death.  Under section 409A, death is a permissible payment event.  However, some employment agreements state that payment will be made within a specified period after the employer receives notice or evidence of the death.  Notice or evidence of death is not a fixed date or specified period and therefore not a fixed payment date under section 409A.  Accordingly, a provision that states, “the Company shall pay to the executive’s beneficiary a death benefit equal to X following receipt of notice of the participant’s death” would not comply with section 409A.  A provision stating that “the Company shall pay the executive’s beneficiary a death benefit equal to X within 90 days of the executive’s death” would comply with section 409A.

CONCLUSION

We strongly recommend that employers carefully review their executive employment agreements for compliance with section 409A as well as the operational aspects of any benefits subject to Section 409A.