Closely-held businesses often rely heavily on a small group of key employees to help their businesses succeed. Given the value of these key employees to the business, it is not uncommon for the business to offer them certain types of additional executive compensation, in addition to standard base salary and participation in typical employee welfare benefits and qualified retirement plans. It is in these other arrangements where Section 409A issues may arise. Businesses should be warned that entering into such arrangements without a basic understanding of how and when to comply with Section 409A may lead to unintended tax consequences for the exact group of employees that they are trying to incentivize.
In this post, we will focus solely on executive employment agreements, as there are a number of areas embedded within these types of contracts that may result in Section 409A compliance issues.
Severance payments are the most prevalent form of “deferred compensation” found in an employment agreement. As a reminder, any amount to which a service provider has a legally binding right and which is or may be payable in a subsequent calendar year will be “deferred compensation” for purposes of Section 409A, unless a statutory exception applies. An executive who is party to an employment agreement providing for severance payments upon a termination of employment has a legally binding right to those payments in the year in which the employment agreement is entered into, notwithstanding the fact that the payments will not be triggered until sometime later following an actual termination of employment. Therefore, by definition, severance payments are deferred compensation and must comply with Section 409A.
Most severance payments fit within one of two exceptions for Section 409A purposes.
The short-term deferral exception provides that amounts payable within 2 ½ months of the end of the year in which they become vested are excluded from Section 409A. When an agreement provides for a lump sum severance payment or a short stream of installment payments, severance will typically be exempt from Section 409A under this exception.
Separation Pay Exemption
The “separation pay exemption” provides a Section 409A safe harbor for any amount payable solely upon an involuntary separation from service to the extent (i) it does not exceed two times the lesser of the employee’s annualized compensation for the year prior to the year of termination or the Code section 401(a)(17) limit for the year of termination, and (ii) it is required to be paid no later than the last day of the second taxable year of the employee following the year of termination.
While it would seem that most severance arrangements would safely fit within one of these two exceptions, their application may depend on two other concepts that are typically found in executive employment agreements: termination for “good reason,” and a release of claims requirement.
Considering the latter first, severance pursuant to an employment agreement is often conditioned upon the execution of a release of claims by the executive. An agreement that provides for payment of severance upon the execution of a release, without further specifying the deadline for execution of that release, will remove a lump sum severance payment from the short-term deferral exception because the payment of severance is now dependent on the employee taking an action which may or may not result in payment within the short-term deferral window. Such a severance provision will also fail to comply with Section 409A because, as described in our prior post, the payment schedule for deferred compensation must be objectively determinable at the time the parties entered into the agreement. This is a perfect example of a typical drafting error in a post-409A executive employment agreement.
A properly drafted release requirement under Section 409A should provide for a limited time for return of an executed release. It must, then, either hardwire a date for payment of the severance thereafter or, alternatively, provide for a payment during a period of ninety (90) days or less following termination, further specifying that if this period spans two calendar years, the payment will be made in the second calendar year. This approach would provide for severance payments that are either exempt from Section 409A under the short-term deferral exception or that comply with Section 409A, as they are now payable upon a separation from service (i.e., a permissible Section 409A trigger event) at an objectively determinable time.
In addition to navigating the release language requirements, if an agreement provides for a “good reason” termination by an executive resulting in severance payments, amounts payable on a termination of employment may or may not be deemed to be payable solely on an “involuntary termination of employment” depending on how closely the definition of “good reason” lines up with the definition contained in the Treasury Regulations under Section 409A. If the IRS deems a “good reason” definition to be too lenient, the severance will be deemed “vested” when the agreement is entered into and will not be deemed payable solely upon an “involuntary termination of employment” such that neither the short-term deferral exception, nor the separation pay exemption, will be applicable to these severance payments.
Bonuses may also present Section 409A issues. Bonuses that are purely discretionary do not give rise to a legally binding right to deferred compensation and thus do not present a problem. On the other hand, an agreement drafted to entitle an executive to a bonus to be determined in accordance with a performance metric or upon the occurrence of an event that is not a permissible Section 409A payment trigger may give rise to deferred compensation. If no payment timing is provided in the agreement, or if the agreement provides for open-ended timing such as “upon completion of the applicable year’s audit,” this bonus payment will not comply with Section 409A. At a minimum, a calendar year of payment should be specified in order to assure that this payment is made at a fixed time.
Additionally, payment of a bonus upon the occurrence of an event such as upon the completion of an IPO, will not satisfy Section 409A because an IPO is not a permissible payment event. This latter issue can be solved by including some language to the effect that this payment will be paid in the discretion of the Company upon the occurrence of the event, though this approach may not give the executive enough comfort. An alternative is to require the executive to remain employed through the date of the event, which is likely the intent of such a bonus provision in any event. Why does this solve our problem? Because now you have converted vested deferred compensation payable on an impermissible trigger into an unvested amount that can satisfy the short-term deferral exception to 409A if the bonus is required to be paid within 2 ½ months of the end of the calendar year in which the IPO takes place (i.e., the “vesting date”).
Taxable Health Insurance and Reimbursements
Taxable health insurance and reimbursement arrangements are also subject to Section 409A, and thus must be drafted accordingly. Some required provisions include an objective period for payment, an outside date for payment following the date the expense was incurred, and language that a right to reimbursement is not subject to liquidation or exchange for another benefit.
As you can see, an employment agreement can become a virtual Section 409A obstacle course if careful attention is not paid to the concept of deferred compensation. In our next post, we will focus on other forms of nonqualified deferred compensation.