Ask most closely-held business owners what words come to mind when they hear the names “Enron” and “Worldcom” and many would say things like “bankruptcy,” “failure,” “scandal” and “greed.”    Ask those same business owners what impact those two names had on the ways they are able compensate their key employees and most would likely say there couldn’t possibly be a connection between these two multibillion dollar collapses and their own businesses.     They would be wrong.

Shortly before each of Enron and Worldcom declared bankruptcy, executives of each withdrew their account balances from nonqualified deferred compensation plans, accelerating these companies’ bankruptcies while simultaneously leaving the rank and file employees, as well as the companies’ shareholders, with little or nothing.  In 2004, in order to prevent similar abuses in the future, Congress enacted Section 409A of the Internal Revenue Code.  Section 409A imposes a significant series of restrictions on a broad variety of compensation arrangements that fit within the definition of “nonqualified deferred compensation,” with harsh consequences for failure to comply with this complicated new regime.

What is Section 409A?

The IRS spent over 400 pages describing the intricate workings of Section 409A in detailed Treasury Regulations that became final on January 1, 2010.  Simply stated, under Section 409A, certain requirements relating to the timing of payments of deferred compensation must be satisfied.  If they are not, all amounts deferred under a nonqualified plan (for all taxable years) are currently includible in the service provider’s gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the service provider’s rights to the compensation are conditioned upon the performance of substantial services or upon the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings).

Those payment timing requirements provide that if a service provider has a legally binding right to compensation that is, or could be, payable in a future taxable year, that compensation must be required to be paid, and may only be paid, upon one of six permissible payment triggers:

  • (i) death,
  • (ii) disability,
  • (iii) a “separation from service”,
  • (iv) a “change in control”,
  • (v) an unforeseeable emergency or
  • (vi) on a fixed date or pursuant to a fixed schedule, each as specifically defined for purposes of Section 409A.

This seems simple enough and, yet, the sheer volume of the applicable Treasury Regulations should serve to alert any tax practitioner that complying with Section 409A is anything but simple.

There are per se, definitional and statutory exceptions and exemptions to Section 409A, such as tax-qualified plans, “short-term deferrals” and “separation pay plans.”

Furthermore, there are the all of the additional nuances embedded within these central concepts – rules applicable to key employees of public companies only, provisions that must be contained in writing in order to be operative, documentary failures, operational failures, permissible accelerations, rules surrounding initial and subsequent deferrals, and aggregation rules among different types of plans.   The list goes on and on.

 What Types of Arrangements are Subject to Section 409A?

Rather than amend the Bankruptcy Code, or draft targeted regulations to address the bad acts of a select few in positions to wreak havoc on public company shareholders, Congress took a “one size fits all” approach to answering this question.   Painting with a broad brushstroke, Congress swept up a variety of compensation arrangements into the panoply that is the domain of Section 409A.  These include:

Employment agreements providing for severance

  • Bonus plans
  • Stock options and other types of equity compensation
  • Post-retirement reimbursements
  • Supplemental executive retirement plans
  • Change in control arrangements
  • Retention bonuses
  • Employee elective salary/bonus deferrals

Any of the above may give rise to nonqualified compensation which must be paid in accordance with Section 409A.

What happens is I get it wrong?

A violation of Section 409A results in immediate taxation to the executive of all vested rights under any covered compensation arrangement prior to payment, in addition to a 20% penalty and premium interest charges.  This draconian result is even harder to swallow in light of the following two points:  (i)  compliance with Section 409A can be a daunting task, requiring strict adherence to detailed regulations which little or no room for error; and (ii) despite the fact that the company usually dictates the terms of payment, it is the service provider who is hit with the lion’s share of consequences for failures to comply with Section 409A.

Looking Ahead

Closely held businesses are uniquely challenged to incentivize and motivate key employees, particularly when subsequent generations may not be interested in, or capable of, managing the company.    Unfortunately, Section 409A is often overlooked by many smaller, privately held companies, as there is still, a decade after its enactment, a pervasive misconception that Section 409A only applies to publicly traded companies.  In our next post, we will touch upon some typical executive compensation structures with an eye toward compliance with Section 409A.    Thereafter, we will focus on equity compensation and, in particular, the role of proper valuation in Section 409A compliance.