Compensation Arrangement Drafters: Beware of IRC Section 409A
by Corey Slagle and Eric Winwood
Incredulity is a common reaction of attorneys (and their clients) who encounter Section 409A of the Internal Revenue Code—“That can’t be right!” “Why does the IRS care?”
409A is the regulatory response to perceived compensation abuses that occurred at Enron. However, 409A regulates far more than the programs that were at issue in Enron. The 600 pages (and counting) of 409A guidance impact, for example, employment agreements, stock options, commissions and reimbursement policies of large and small companies alike.
409A compliance is not easy. Not only must the written terms of a deferred compensation arrangement satisfy 409A, but the arrangement must also be operated in compliance with those rules. And 409A violations impose significant harm on employees. Penalties include accelerated federal income taxation, plus a 20 percent excise tax and interest charges (some states have similar penalties).
Identifying all potential 409A errors is beyond the scope of this article. However, below are three regularly seen drafting errors.
Your friend has been hired by a start-up company. For peace of mind, the start-up offers her a severance package if she is involuntarily terminated. Upon such a termination, your friend will receive continued salary payments as severance for three years. However, the start-up insists that severance will only commence if your friend signs a release of claims at termination (i.e., in return for severance, your friend agrees not to sue the start-up). While this arrangement seems reasonable, there is a 409A issue lurking.
Employee discretion, whether or not exercised, to control the time of payment is antithetical to 409A. When severance is dependent upon signing a release, an employee hypothetically has control over the timing of the severance. If the employee is terminated in December, for example, the employee could wait until the following January to sign the release, thereby delaying the start of severance and deferring the tax on the first few payments into the following year.
This issue is not merely academic, in that, IRS guidance has addressed the subject on a couple of occasions. This arrangement should be drafted in a manner that eliminates employee discretion to affect timing of the severance. For example, provide that severance commences on a fixed date (e.g., 60 days after termination), but only if the release is effective as of that date. Or provide that if the window for returning the release straddles the end of one year and the beginning of another, payment will begin in the second year regardless of when the release is signed.
Your school district client agrees to reimburse teachers for personal expenses incurred while chaperoning school trips. The school limits reimbursements to $500 per school year. Could 409A be a stumbling block?
Yes, because the IRS has concluded that certain reimbursements could hypothetically be used to disguise deferred compensation. As a result, reimbursements are addressed in 409A guidance.
Compliance requires (i) clearly describing the reimbursable expenses, (ii) fixing the period in which the expenses can be incurred, (iii) reimbursing by the end of the year following the year in which the expense is incurred, (iv) refraining from cashing out the reimbursement right and (v) precluding the amount of one year’s reimbursements from affecting the amount in another year.
The problem with the school’s proposal is the $500 limit. If the school year is not a calendar year, the amount of reimbursable expenses incurred in the first calendar year will limit the reimbursable expenses in the second year. Consider drafting the $500 limit as two component limits—$250 during the first and $250 in the second calendar year (of the school year).
Your client is acquiring a company and wants to replace the company’s existing employment contracts with new contracts that match your client’s regular form of employment agreement.
Replacing the contracts could cause a 409A violation. Once an arrangement establishes how deferred compensation payments will be made, 409A severely limits the ability to make any changes to the time or form of those payments. For example, if the old contracts provide severance in the form of three years of continued salary, the new contract could not provide severance as a lump-sum payment at termination. Doing so would violate 409A’s prohibitions on accelerating the time of payment.
Practitioners should be take particular care when varying the time and form of payment of pre-existing compensation rights whenever an old arrangement is replaced.
Corey Slagle is an employee benefits associate at Bryan Cave, LLP, and can be reached at email@example.com. Eric Winwood is an employee benefits partner at Baker Botts, LLP, and can be reached at firstname.lastname@example.org.