Our last post described the portions of an executive employment agreement that may be impacted by Section 409A.  However, Section 409A may also impact the structure of other, less traditional compensation paid to key employees.  In the context of a closely-held business, two commonly-encountered alternative compensation arrangements used outside of the context of an individual employment agreement are (1) a stand-alone deferred compensation plan and (2) phantom equity arrangements.

(1) Nonqualified Deferred Compensation Plans

Nonqualified deferred compensation plans are often used to supplement retirement savings for those executives who have maxed out their contributions to qualified retirement plans.  An example of such a plan would be a supplemental executive retirement plan (“SERP”), under which the company would agree to provide a stated amount of supplemental retirement income to the executive and/or his/her family once certain vesting conditions are met by the executive. Amounts are typically paid out of a SERP upon a stated retirement age or upon the death or disability of the executive.   In terms of Section 409A compliance, the burden at the outset on the Company is relatively low, as SERPs typically provide for payment upon otherwise permissible Section 409A payment events.    If kept fairly simple and straightforward, and operated strictly in accordance with the terms of the plan, a SERP will generally comply with Section 409A.

On the other hand, if the executive is given flexibility with respect to elective salary deferrals, deferrals of amounts otherwise payable under the SERP, or acceleration of payments scheduled to be made from a SERP, Section 409A will once again provide a fairly stringent roadmap for how to draft these additional pieces of the plan.   For example, the Treasury Regulations under Section 409A provide specific rules as to the timing of both initial and subsequent deferrals of deferred compensation.   There are also restrictions on an executive’s ability to accelerate payments under a plan subject to Section 409A.  If these provisions are not carefully drafted, all amounts under the plan may be subject to penalties under Section 409A, whether or not the executive ever actually receives the payments.

 (2) Phantom Equity

Sometimes, the closely-held business owner wants the ownership of the company to stay within the hands of a small group, particularly in the context of a family-owned business.  Notwithstanding that desire, savvy business owners often recognize that the best way to incentivize a key member of their staff is to provide them with a share in the economic growth of the company.   The issuance of phantom equity often bridges this gap.   Phantom equity provides a contractual right to the economic equivalent of equity ownership in a business, without the issuance of an actual equity interest.   When granted to a service provider, phantom equity results in compensation to the individual that, when payable in future years, falls squarely within the definition of deferred compensation for Section 409A purposes.

Phantom equity must be structured to comply with, or be exempt from, Section 409A.  An advantage to drafting deferred compensation to be exempt from Section 409A is that the executive and the company will have greater flexibility in subsequently deferring and/or accelerating these amounts, as the restrictions contained within Section 409A will not apply to amounts that are not subject to Section 409A.    The short-term deferral exception can be used to exempt payments in respect of phantom equity if the executive must be employed by the company on, or closely within proximity of, the specified payment date, as this employment condition gives rise to a substantial risk of forfeiture.   In that instance, payment will always be made within the short-term deferral window (i.e., within 2 ½ months following the end of the calendar year in which the substantial risk of forfeiture lapses).

If the goal is provide for an incentive that can be earned and vested over some period of time, regardless of the executive’s provision of services through the payment date, phantom equity will become deferred compensation and must be paid only on a permissible Section 409A payment event.  Change in control, separation from service, death and disability are common permissible Section 409A triggers for payments in respect of phantom equity.   Other events, such as the occurrence of an IPO or the achievement of a revenue threshold, are not among the stated permissible Section 409A triggers and thus cannot be used for this purpose.

In our final post, we will move to Section 409A considerations for traditional equity incentive awards, with a discussion of the importance of proper valuation in this context.