Meeting the Section 409A Deadline

With a last-minute extension by the IRS, the final regulations adopted under Section 409A of the Internal Revenue Code now impose a hard Dec. 31, 2008 deadline on making necessary amendments to deferred compensation arrangements for employees, directors, and certain independent contractors of private, not-for-profit, and public companies in order to avoid federal excise taxes at a rate of 20% (plus retroactive interest). Such employees, directors and independent contractors are referred to in the 409A regulations and in this article as 'service providers' and the entities for which they provide services are referred to as 'service recipients,' but it may be easier if you think about 'employees' and 'employers.' The extension to Dec. 31, 2008 should not dissuade employers from immediately beginning (or continuing) the task of reviewing, redesigning and formally amending their deferred compensation plans. This is painstaking work and requires participation of the Board, Human Resources and individual executives.

'Good faith' compliance with Section 409A has been required since Jan. 1, 2005, but with the publication of several hundred pages of final regulations in April 2007 and subsequent guidance, the IRS has set a Dec. 31, 2008 deadline for full compliance with the statute and regulations, in form and operation. If you fail to act by this deadline, service providers, including your senior executives, will be subject to the punitive and confiscatory taxes and penalties imposed by Section 409A: Deferred compensation that is subject to Section 409A will be taxed at vesting (not at payment), will be subject to an excise tax penalty of 20%, and will be subject to interest from the date of non-compliance retroactive to the date of vesting. Failure to comply with Section 409A can result in total federal income and excise taxes on deferred compensation at a rate as high as 55% (plus retroactive interest), namely a maximum federal income tax rate of 35% plus the 20% excise tax penalty. Moreover, there is an additional 20% state penalty if the service provider resides in California, resulting in a combined federal and state tax rate as high as 85% (before the effect of federal tax deductions for state income taxes) plus retroactive interest.

Common types of arrangements that may be subject to Section 409A include (but are not limited to) the following:

• employment agreements, which may include formal agreements, letter agreements or offer letters, expatriate agreements and retention agreements;
• all severance or separation pay provisions or agreements;
• annual and multi-year bonus and commission plans;
• traditional deferred compensation plans, including so-called 'SERPS';
• any agreement with a change-in-control provision;
• split-dollar life insurance arrangements;
• corporate transaction 'earn-out' arrangements;
• stock options, SARs, phantom stock plans, and other equity awards (excluding restricted stock, which is generally exempt, tax-qualified incentive stock options and tax-qualified employee stock purchase plans);
• 457(f) deferred compensation arrangements for non-profits;
• reimbursement arrangements covering multi-years;
• back-to-back private equity deferral arrangements;
• foreign retirement arrangements covering U.S. employees; and
• any other nonqualified deferred compensation plan.

For Immediate Action

First, immediately identify all of your nonqualified deferred compensation arrangements. In case of doubt, assume that Section 409A applies to any arrangement that provides for a payment or a benefit to a service provider.

Second, make any necessary changes to your nonqualified deferred compensation arrangements in order to comply with Section 409A by Dec. 31, 2008. This potentially monumental task could require discussions at the Board level and with executives to determine the best route for 409A compliance.

Third, the proposed changes may have to be approved by the compensation committee of the company's board of directors or other corporate body with the authority to approve the proposed changes, by Dec. 31, 2008.

Fourth, arrange for the execution of the proposed amendment by all necessary parties (including, in some cases, the service providers) by Dec. 31, 2008.

Fifth, make sure that controls are implemented to ensure operational compliance with the new rules and the new provisions of your plans.

What Is 'Deferred Compensation'?

Section 409A applies to plans that provide for deferred compensation, except for tax-qualified plans, Section 457(b) plans, and many vacation, sick leave, disability, and death benefit plans. A plan provides for deferred compensation if: 1) the service provider has a 'legally binding right' (including a conditional right, but not including a payment or benefit that may be unilaterally reduced or eliminated by the employer) to a payment or benefit that is or may be payable in a later year; and 2) the payment or benefit is not subject to a 409A exemption.

Exemptions from Coverage

Many compensation arrangements are exempt from 409A coverage. The exemptions provide a quick 'out' from the 409A consequences and compliance issues. The most useful exemption is the 'short-term deferral' exemption, under which 409A does not apply if the payment must be made shortly after it becomes vested, specifically, no later than the fifteenth day of the third month following the later of: 1) the end of the service provider's taxable year; or 2) the end of the service recipient's taxable year in which the payment or benefit becomes vested.

Other exemptions include:

• certain stock options and stock appreciation rights with exercise prices not greater than fair market value at grant;
• certain severance arrangements that provide for payment solely upon an involuntary separation from service or a voluntary separation for good reason;
• certain deductible reimbursements;
• reasonable outplacement services;
• reasonable reimbursement of medical expenses that are paid during the COBRA period;
• certain in-kind and direct payments by the service recipient for goods and services;
• payments that do not exceed an amount specified in the regulations ($15,500 in 2007); and
• payments related to indemnification agreements.

409A Compliance

If a payment or benefit is 'deferred compensation' and is not subject to an exemption, it must comply with the substantive requirements of Section 409A. The substantive requirements fall into two main categories: requirements as to timing of elections to defer compensation and requirements as to timing of payment of deferred compensation. Generally, all deferral elections must be made and fixed before the beginning of the year in which the compensation is earned and deferred compensation may only be paid upon the occurrence of one of the following events:

separation from service (subject to a six-month delay for certain senior executives and employees who are considered significant owners of public companies, called 'specified employees' in the regulations);

• disability;
• death;
• change of control;
• unforeseeable emergency; or
• a specific date or pursuant to a fixed schedule.

Illustrations

For purposes of illustration, we will take the following simple examples of nonqualified deferred compensation and how they may need to be changed to comply with Section 409A. The methods of 'fixing' the agreements described below present only a few of many different alternatives for complying with Section 409A:

Example No. 1: Chris, the newly hired CEO of the company, has an employment agreement that provides that he will be paid a $400,000 retention bonus if he remains employed for one year. The retention bonus is payable any time, at the company's discretion, within two years after the first anniversary of the start of employment. Chris has a legally binding right to the retention bonus upon execution of the agreement, even though it is subject to the performance of substantial services, because the event of forfeiture is non-discretionary and objective. The short-term deferral exemption would not be applicable because the bonus may be paid more than 2-1/2 months following the end of the year in which Chris becomes vested. Therefore, the retention bonus would be taxable upon vesting and would be subject to the 20% excise tax penalty.

Fixing Chris's Agreement

Chris's agreement for payment of the retention bonus should be amended on or before Dec. 31, 2008 to comply with the short-term deferral exemption or to provide a fixed schedule for payments.

The short-term deferral exemption applies if the payment occurs before the later of: 1) the fifteenth day of the third month following the end of Chris's first taxable year in which the right to payment is vested; or 2) the fifteenth day of the third month following the end of the company's first taxable year in which the right to payment is vested. Assuming that Chris and the company are both calendar year taxpayers, the agreement would be amended to provide that all of the retention bonus payments would be made not later than March 15 of the calendar year following the first anniversary of the agreement. Alternatively, if the company wants to delay payments, the agreement would be amended to provide for payment on a later fixed date, such as the third anniversary of employment.

In either case, these amendments must occur before the end of 2008.

Example No. 2: Helen is an executive of a public company and is a 'specified employee' under the 409A regulations. Her annual salary and bonus total $350,000. Under her employment agreement, if she is terminated without cause or she resigns for 'good reason' Helen is entitled to $700,000, payable not later than three years after termination. Because payments under the agreement may be paid after March 15 of the year following separation, those payments do not fall within the 'short-term deferral' exemption. Moreover, since Helen is a 'specified employee,' her separation payments must be delayed at least six months (or if earlier, death) and thus the possibility that the payments may be made earlier results in a violation of Section 409A.

Fixing Helen's Agreement

Section 409A provides several ways to avoid the application of the six-month (or if earlier, death) delay for severance pay for specified employees:

• If the severance pay is payable solely for termination by the company or resignation for good reason, then Helen is considered to become vested at termination of employment and if the payment must be made within 2-1/2 months after the year in which separation occurs, the short term deferral exemption applies. Thus, Helen's agreement may be modified on or before Dec. 31, 2008 as follows to comply with the short term deferral exemption.
• Make certain that the definition of 'good reason' in Helen's employment agreement is consistent with the definition of 'good reason' in the 409A regulations.
• Make sure all severance payments must be made within the short-term deferral time frame.

If the company wants to extend Helen's payments beyond the short-term deferral time frame, because, for example, it wants to continue to pay Helen via its normal payroll practices, severance payments payable solely for termination by the company or resignation for good reason are exempt to the extent that the severance pay meets the following two requirements: 1) the separation pay does not exceed two times the lesser of: a) the sum of the service provider's annualized compensation (normal salary rate and normal bonus) as of the separation from service; and b) the maximum amount of compensation that may be taken into account under a qualified plan under Internal Revenue Code Section 401(a)(17) for the year in which the separation from service occurs ($225,000 in 2007); and 2) the severance pay must be paid no later than the last day of the service provider's second taxable year following the taxable year in which the separation from service occurred.

Accordingly, to take advantage of this exception, Helen's agreement should be reviewed and amended on or before Dec. 31, 2008 to:

• Make certain that the definition of 'good reason' in Helen's employment agreement is consistent with the definition in the Section 409A regulations.
• Change Helen's agreement to provide that the payments described above (i.e., $450,000 for 2007) will be completed by the end of the second taxable year following Helen's separation.
• Delay the remainder of Helen's payments for six months (or if earlier, death) following Helen's separation and provide for a fixed schedule for such payments.

Conclusion

Start now and you will enjoy a Happy New Year 2007 and 2008.

Frederick D. Lipman and Barry L. Klein are partners at Blank Rome LLP. Wilhelm L. Gruszecki is Of Counsel.

With a last-minute extension by the IRS, the final regulations adopted under Section 409A of the Internal Revenue Code now impose a hard Dec. 31, 2008 deadline on making necessary amendments to deferred compensation arrangements for employees, directors, and certain independent contractors of private, not-for-profit, and public companies in order to avoid federal excise taxes at a rate of 20% (plus retroactive interest). Such employees, directors and independent contractors are referred to in the 409A regulations and in this article as 'service providers' and the entities for which they provide services are referred to as 'service recipients,' but it may be easier if you think about 'employees' and 'employers.' The extension to Dec. 31, 2008 should not dissuade employers from immediately beginning (or continuing) the task of reviewing, redesigning and formally amending their deferred compensation plans. This is painstaking work and requires participation of the Board, Human Resources and individual executives.

'Good faith' compliance with Section 409A has been required since Jan. 1, 2005, but with the publication of several hundred pages of final regulations in April 2007 and subsequent guidance, the IRS has set a Dec. 31, 2008 deadline for full compliance with the statute and regulations, in form and operation. If you fail to act by this deadline, service providers, including your senior executives, will be subject to the punitive and confiscatory taxes and penalties imposed by Section 409A: Deferred compensation that is subject to Section 409A will be taxed at vesting (not at payment), will be subject to an excise tax penalty of 20%, and will be subject to interest from the date of non-compliance retroactive to the date of vesting. Failure to comply with Section 409A can result in total federal income and excise taxes on deferred compensation at a rate as high as 55% (plus retroactive interest), namely a maximum federal income tax rate of 35% plus the 20% excise tax penalty. Moreover, there is an additional 20% state penalty if the service provider resides in California, resulting in a combined federal and state tax rate as high as 85% (before the effect of federal tax deductions for state income taxes) plus retroactive interest.

Common types of arrangements that may be subject to Section 409A include (but are not limited to) the following:

• employment agreements, which may include formal agreements, letter agreements or offer letters, expatriate agreements and retention agreements;
• all severance or separation pay provisions or agreements;
• annual and multi-year bonus and commission plans;
• traditional deferred compensation plans, including so-called 'SERPS';
• any agreement with a change-in-control provision;
• split-dollar life insurance arrangements;
• corporate transaction 'earn-out' arrangements;
• stock options, SARs, phantom stock plans, and other equity awards (excluding restricted stock, which is generally exempt, tax-qualified incentive stock options and tax-qualified employee stock purchase plans);
• 457(f) deferred compensation arrangements for non-profits;
• reimbursement arrangements covering multi-years;
• back-to-back private equity deferral arrangements;
• foreign retirement arrangements covering U.S. employees; and
• any other nonqualified deferred compensation plan.

For Immediate Action

First, immediately identify all of your nonqualified deferred compensation arrangements. In case of doubt, assume that Section 409A applies to any arrangement that provides for a payment or a benefit to a service provider.

Second, make any necessary changes to your nonqualified deferred compensation arrangements in order to comply with Section 409A by Dec. 31, 2008. This potentially monumental task could require discussions at the Board level and with executives to determine the best route for 409A compliance.

Third, the proposed changes may have to be approved by the compensation committee of the company's board of directors or other corporate body with the authority to approve the proposed changes, by Dec. 31, 2008.

Fourth, arrange for the execution of the proposed amendment by all necessary parties (including, in some cases, the service providers) by Dec. 31, 2008.

Fifth, make sure that controls are implemented to ensure operational compliance with the new rules and the new provisions of your plans.

What Is 'Deferred Compensation'?

Section 409A applies to plans that provide for deferred compensation, except for tax-qualified plans, Section 457(b) plans, and many vacation, sick leave, disability, and death benefit plans. A plan provides for deferred compensation if: 1) the service provider has a 'legally binding right' (including a conditional right, but not including a payment or benefit that may be unilaterally reduced or eliminated by the employer) to a payment or benefit that is or may be payable in a later year; and 2) the payment or benefit is not subject to a 409A exemption.

Exemptions from Coverage

Many compensation arrangements are exempt from 409A coverage. The exemptions provide a quick 'out' from the 409A consequences and compliance issues. The most useful exemption is the 'short-term deferral' exemption, under which 409A does not apply if the payment must be made shortly after it becomes vested, specifically, no later than the fifteenth day of the third month following the later of: 1) the end of the service provider's taxable year; or 2) the end of the service recipient's taxable year in which the payment or benefit becomes vested.

Other exemptions include:

• certain stock options and stock appreciation rights with exercise prices not greater than fair market value at grant;
• certain severance arrangements that provide for payment solely upon an involuntary separation from service or a voluntary separation for good reason;
• certain deductible reimbursements;
• reasonable outplacement services;
• reasonable reimbursement of medical expenses that are paid during the COBRA period;
• certain in-kind and direct payments by the service recipient for goods and services;
• payments that do not exceed an amount specified in the regulations ($15,500 in 2007); and
• payments related to indemnification agreements.

409A Compliance

If a payment or benefit is 'deferred compensation' and is not subject to an exemption, it must comply with the substantive requirements of Section 409A. The substantive requirements fall into two main categories: requirements as to timing of elections to defer compensation and requirements as to timing of payment of deferred compensation. Generally, all deferral elections must be made and fixed before the beginning of the year in which the compensation is earned and deferred compensation may only be paid upon the occurrence of one of the following events:

separation from service (subject to a six-month delay for certain senior executives and employees who are considered significant owners of public companies, called 'specified employees' in the regulations);

• disability;
• death;
• change of control;
• unforeseeable emergency; or
• a specific date or pursuant to a fixed schedule.

Illustrations

For purposes of illustration, we will take the following simple examples of nonqualified deferred compensation and how they may need to be changed to comply with Section 409A. The methods of 'fixing' the agreements described below present only a few of many different alternatives for complying with Section 409A:

Example No. 1: Chris, the newly hired CEO of the company, has an employment agreement that provides that he will be paid a $400,000 retention bonus if he remains employed for one year. The retention bonus is payable any time, at the company's discretion, within two years after the first anniversary of the start of employment. Chris has a legally binding right to the retention bonus upon execution of the agreement, even though it is subject to the performance of substantial services, because the event of forfeiture is non-discretionary and objective. The short-term deferral exemption would not be applicable because the bonus may be paid more than 2-1/2 months following the end of the year in which Chris becomes vested. Therefore, the retention bonus would be taxable upon vesting and would be subject to the 20% excise tax penalty.

Fixing Chris's Agreement

Chris's agreement for payment of the retention bonus should be amended on or before Dec. 31, 2008 to comply with the short-term deferral exemption or to provide a fixed schedule for payments.

The short-term deferral exemption applies if the payment occurs before the later of: 1) the fifteenth day of the third month following the end of Chris's first taxable year in which the right to payment is vested; or 2) the fifteenth day of the third month following the end of the company's first taxable year in which the right to payment is vested. Assuming that Chris and the company are both calendar year taxpayers, the agreement would be amended to provide that all of the retention bonus payments would be made not later than March 15 of the calendar year following the first anniversary of the agreement. Alternatively, if the company wants to delay payments, the agreement would be amended to provide for payment on a later fixed date, such as the third anniversary of employment.

In either case, these amendments must occur before the end of 2008.

Example No. 2: Helen is an executive of a public company and is a 'specified employee' under the 409A regulations. Her annual salary and bonus total $350,000. Under her employment agreement, if she is terminated without cause or she resigns for 'good reason' Helen is entitled to $700,000, payable not later than three years after termination. Because payments under the agreement may be paid after March 15 of the year following separation, those payments do not fall within the 'short-term deferral' exemption. Moreover, since Helen is a 'specified employee,' her separation payments must be delayed at least six months (or if earlier, death) and thus the possibility that the payments may be made earlier results in a violation of Section 409A.

Fixing Helen's Agreement

Section 409A provides several ways to avoid the application of the six-month (or if earlier, death) delay for severance pay for specified employees:

• If the severance pay is payable solely for termination by the company or resignation for good reason, then Helen is considered to become vested at termination of employment and if the payment must be made within 2-1/2 months after the year in which separation occurs, the short term deferral exemption applies. Thus, Helen's agreement may be modified on or before Dec. 31, 2008 as follows to comply with the short term deferral exemption.
• Make certain that the definition of 'good reason' in Helen's employment agreement is consistent with the definition of 'good reason' in the 409A regulations.
• Make sure all severance payments must be made within the short-term deferral time frame.

If the company wants to extend Helen's payments beyond the short-term deferral time frame, because, for example, it wants to continue to pay Helen via its normal payroll practices, severance payments payable solely for termination by the company or resignation for good reason are exempt to the extent that the severance pay meets the following two requirements: 1) the separation pay does not exceed two times the lesser of: a) the sum of the service provider's annualized compensation (normal salary rate and normal bonus) as of the separation from service; and b) the maximum amount of compensation that may be taken into account under a qualified plan under Internal Revenue Code Section 401(a)(17) for the year in which the separation from service occurs ($225,000 in 2007); and 2) the severance pay must be paid no later than the last day of the service provider's second taxable year following the taxable year in which the separation from service occurred.

Accordingly, to take advantage of this exception, Helen's agreement should be reviewed and amended on or before Dec. 31, 2008 to:

• Make certain that the definition of 'good reason' in Helen's employment agreement is consistent with the definition in the Section 409A regulations.
• Change Helen's agreement to provide that the payments described above (i.e., $450,000 for 2007) will be completed by the end of the second taxable year following Helen's separation.
• Delay the remainder of Helen's payments for six months (or if earlier, death) following Helen's separation and provide for a fixed schedule for such payments.

Conclusion

Start now and you will enjoy a Happy New Year 2007 and 2008.

Frederick D. Lipman and Barry L. Klein are partners at Blank Rome LLP. Wilhelm L. Gruszecki is Of Counsel.