Understanding Section 409A and Its Implications for Employers and Employment Agreements
Background: Why was Section 409A of the Internal Revenue Code enacted?
Prior to the enactment of Section 409A, no single section of the Internal Revenue Code governed taxation of nonqualified deferred compensation. Income inclusion of deferred compensation was historically governed by a variety of tax principles, including the doctrines of constructive receipt and economic benefit and Section 83, which deals with transfers of property in connection with the performance of services. These were applied on an ad hoc basis of facts and circumstances. Section 409A does not replace these principles, but provides clearer guidance where appliable.
The primary driving force for the enactment of Section 409A was the Enron bankruptcy. In the weeks prior to filing for bankruptcy, 126 highly compensated employees were allowed to accelerate the payment of $53 million of deferred compensation, leaving others with $435 million of deferred compensation to become unsecured creditors of Enron in the bankruptcy. It was reported that approximately 20,000 employees lost their jobs, and between the Enron savings and stock ownership plans and this deferred compensation, lost approximately $2 billion. In 2002, the Joint Committee on Taxation began a review of Enron’s deferred compensation practices, and determined that "changes should be made in the rules relating to deferred compensation."
What are the basics of Section 409A?
Section 409A deals only with deferred compensation, so the first question always is whether any compensation is earned currently with payment for those services to be made at a later date. Section 409A applies only to non-qualified deferred compensation. It does not apply to qualified plans described in Section 401 of the Internal Revenue Code, such as 401(k) plans.
Section 409A focuses on the timing of distributions. Once the timing of a distribution is fixed, the distribution may not be accelerated or delayed, unless that is done in the manner approved in the Section 409A Regulations (or the "Regulations"). This was the primary issue in Enron.
All amounts of compensation deferred under a nonqualified plan are taxable when those payments are not subject to “a substantial risk of forfeiture” unless the plan limits the times distributions can be made to those permitted under Section 409A. Compensation is considered to be subject to a substantial risk of forfeiture if a) entitlement to that amount is conditioned upon the performance of substantial future services by any person, or (b) the possibility of forfeiture is substantial. It is intended that a substantial risk of forfeiture may not be used to manipulate the timing of the inclusion of income.
Distributions are permitted only upon one of the following: separation from service, death, disability, a change in control, unforeseeable emergencies or a specific time either stated or objectively determined. Other than death, the meaning each of these terms are terms is explained in detail in the Section 409A Regulations.
There are specific rules about when a deferral election can made and how the deferral may subsequently be changed.
If the Section 409A rules are not strictly followed, all of the income deferred is taxed in the year there is no longer a substantial risk of forfeiture, which may be when the grant is made. The employee also must pay a penalty equal to 20% of the income deferred, plus interest accrued from the time the deferred compensation should have been included in income. In addition, the IRS may impose reporting, withholding and deposit penalties on the employer for the failure to timely report, withhold and deposit federal income taxes. The 409A violation may be either in the plan document or in the manner in which the plan is actually operated.
What is 409A's Scope of Coverage?
The Regulations state that a nonqualified deferred compensation "plan” is any plan that provides for the deferral of compensation. The term “plan” is very broad. It includes any arrangement, method, program or agreement, whether or not it is considered an employee benefit plan under ERISA. Examples of a “plan” can be employment agreements, severance agreements, change of control agreements, and equity based compensation awards.
If a plan is subject to Section 409A, it MUST BE IN WRITING. A plan may be set forth in one or more documents.
At a minimum, the plan must include the amount to be paid or a formula to determine the amount, the payment schedule or triggering events, and all applicable initial deferral or subsequent deferral elections.
All plans subject to Section 409A can be aggregated, to protect against the abuse of the 409A rules.
How can an employer avoid being subject to 409A?
The best way to avoid the pitfalls of Section 409A is to have a situation which is not subject to Section 409A. Section 409A does not apply to the payment of deferred compensation where the deferral is for only a short period – hence the name “short-term deferral.”
This arises when payment is made actually or constructively during the first taxable year in which the amount is no longer subject to a substantial risk of forfeiture, or during a limited period of time thereafter (this period is often referred to as the “short-term deferral period” or the “applicable 2 1/2 month period.” The short-term deferral period ends the 15th day of the third month following the end of the employee’s taxable year that includes the date on which the employee’s right to payment is no longer subject to a substantial risk of forfeiture (for individuals this is March 15 since individuals have a calendar year), and the 15th day of the third month following the end of the employer’s taxable year that includes the date on which the employee’s right to the payment is no longer subject to a substantial risk of forfeiture. If the employer's taxable year is also the calendar year, this will be the same date.
This is applied very strictly. For example, if a separation from service is the triggering event and the employment agreement contains a severance provision that requires the employee to sign a waiver of claims, and if the applicable law requires that the employee have right of recission for a period of time, the payment is not made until that recission period expires. If that falls after the short-term deferral period ends, the short-term deferral exclusion from Section 409A coverage will not apply.
When may deferred compensation payments be made?
Payments may be made when an employee “separates from service.” However, a “separation from service” can be different than a “termination of employment.” For example, if the employee after the termination of employment provides consulting services to the employer, the employee may not have separated from service.” The 409A Regulations explain how this concept is applied.
Payments may be made upon a disability. The plan must use the definition in the Regulations, which is very narrow and provides that the service provider is near death or has a condition from which the employee is expected to die within a year.
Payments may be made upon the occurrence of certain corporate transactions which result in a “change of control.” That term is also explained in the 409A Regulations and a transaction not described there will not be a permissible reason for a distribution.
There are exceptions for certain severance benefits. Severance payments outside those parameters are not permissible payments.
NO BENEFIT PAYNMENT MAY BE ACCELLERATE OR DEFERRED, except as specially permitted in the Regulations. However, vesting of deferred compensation may be accelerated, delayed, or otherwise changed.
Which equity arrangements are subject to Section 409A?
Stock Options, Stock Appreciation Rights and Partnership Profits Interests, and other equity arrangements may have deferred compensation features, and may be subject to Section 409A.
The issuance of these will not be subject to Section 409A if they have no current value at the time of issuance. For example, if a stock option has an exercise price equal to the fair market value of the underlying stock at the time the option is granted, it is considered to have no value at the time of grant, and therefore no amount of compensation is deferred. The inherent value of the right to purchase stock in the future if the stock increases in value is ignored.
Likewise, if the payment upon a monetizing event for a Stock Appreciation Right or a Profits Interest is the increase in value from the date that instrument is issued, it will mot be subject to Section 409A.
Are Tax Exempt Entities' Deferred Compensation Plans also subject to Section 409A?
Deferred compensation plans of tax-exempt entities are subject to Section 409A in the same manner as for-profit entities.
Before the enactment of Section 409A, the income taxation of income deferred under non-qualified plans of tax-exempt entities was governed by Section 457 of the Internal Revenue Code, which in some cases was less advantageous to the employees than if the employer had been a for-profit entity. That did not change with the enactment of Section 409A.
If you have any questions concerning Section 409A Regulations, please contact any member of our Employee Benefits practice group.