Nuts & Bolts of Section 409A: Practical Issues to Consider ... · Nuts & Bolts of Section 409A:...

www.americanbar.org/jceb

Nuts & Bolts of Section 409A: Practical Issues to Consider in Every Practice

June 9, 2016Sponsored by the ABA Joint Committee on Employee Benefits and the

American College of Employee Benefits Counsel

Moderator: Frank Palmieri, Palmieri & Eisenberg, Princeton, NJPanelists: George H. Bostick, Former Benefits Tax Counsel, U.S. Department of the Treasury

(2009-2015), Washington, DCDaniel L. Hogans, Groom Law Group, Washington, DCVictoria H. Zerjav, Holland & Knight LLP, Stamford, CT

www.americanbar.org/jceb2

Background

• Many forms of nonqualified deferred compensation (NQDC)– elective deferrals to notional accounts, retention

incentives, severance sweeteners and parachutes, excess and supplemental benefit plans, replacements for prior benefits lost by new hires, restricted or deferred phantom stock units, LTIPs, SARs, etc.

• Deductions deferred until service provider’s income inclusion, so limited “tax subsidy”

• Pre-409A, taxation governed by case law, IRS regulations and rulings, mostly focusing on “constructive receipt”


Background (Pre-409A Guidance)

• Case law and rulings dated to at least WWII, and general guidance was provided in Rev. Rul. 60-31, but periodic Treasury/IRS episodes of discomfort– particularly where elective – leading to period of no private rulings

• Later IRS published Rev. Proc. 71-19 conditioning obtaining private letter rulings on (1) initial deferral elections before the year in which related services were performed and (2) substantial forfeiture provisions for the entire deferral period if any other elections were available

• Ruling guidelines did not purport to state the law, appeared more restrictive than prior rulings and case law, and were sometimes ignored


Background (1978 Freeze)

• Early 1978 proposed IRS regulations to currently tax elective deferrals, but Congress quickly enacted a provision prohibiting the IRS from issuing any general guidance more restrictive than the law then in effect

• As NQDC continued to evolve, the 1978 “freeze” inhibited IRS influence on aggressive planning

• “Haircuts” (e.g., 10 % forfeitures) became a popular way of allowing employees to take earlier than scheduled distributions.

• Early distributions from trusts (established as subject to the claims of employer creditors) on the occurrence of employer financial difficulty triggers also appeared


Background (The Snake in the Garden)

• The Enron meltdown precipitated intense new focus on NQDC, with early 2003 JCT report noting executive deferrals of more than $150 million under Enron’s NQDC plans and executives’ receipt shortly before bankruptcy of more than $53 million of accelerated distributions

• Concurrently, rank and file employees were unable to cash out company stock in the company’s 401(k) plan

• JCT recommended developing rules to currently tax where was “effective control over the amount deferred”

• Treasury recommended lifting the 1978 “freeze, but some employers opposed, and tax-writing committees of Congress preferred to write the rules


Background (409A Enacted)

• Number of bills introduced, and ultimately 409A enacted in American Jobs Creation Act of 2004

• Legislative history identifies as key concerns 409A was meant to address arrangements providing security of future payment and control over the deferred amounts– Receiving distributions on request subject to forfeiture

of minimal amounts (haircuts)– Trusts, including rabbi trusts, located offshore (difficult

for creditors to reach)– Employer financial health triggers for payment or

restriction of assets to NQDC payments


Background (Statutory Overview)

• 409A Penalties: violations result in income inclusion for the attempted deferral, an additional 20% tax on the service provider and interest at the underpayment rate plus 1% from the date would have been income

• Initial elections generally (limited performance pay exception) must be made in the year before the year in which services giving rise to the NQDC are rendered

• Further deferrals cannot take effect for 12 months, must be at least 12 months before scheduled payment, and must delay payment for at least 5 years.

• Form of payment specified in plan or initial election


• Distribution constraints: generally permitted only at – Separation from service– Change of control – A time or schedule (not event) fixed at deferral – Death, disability or narrow unforeseeable emergency– No accelerations– For “key employees” distributions on separation from

service must be delayed 6 months• Other: 409A also generally prohibits setting aside assets

for NQDC in offshore trusts and restricting assets based on financial triggers

Background (Statutory Overview)


Problems and Complaints

The structure of 409A creates some inherent problems and others are created by interpretations. Treasury and IRS received a number of suggestions, some of which have been reflected in guidance while others have, for one reason or another, not been. Among other things

– The statute inherently places the penalty on the wrong party, since most individuals with NQDC do not control or administer (or often understand) the NQDC plans covering them

– The regulations, other guidance and corrections are complicated – true, but others say better to stick with the devil you have worked with


Problems and Complaints (continued)

– The substitution rule treating as NQDC (that would generally fail 409A) anything received in substitution for NQDC that an individual gives up is broad and may inhibit needed and desirable changes – e.g., changes to plans or employment agreements to place compensation at risk (or readily clawed back) for a longer period to satisfy corporate governance concerns

– Substitution rule also complicates ad hoc or negotiated partial payments for cycles not yet completed (with vesting and payment on completion) under multi-year LTIP and performance-based bonus structures – e.g., in M&A, downsizing, release cases


Regulations & Guidance

• Final Regulations released April 10, 2007• Detail how plan operation and documentation

requirements are satisfied• Correction Guidance followed• Open items:

• W-2 reporting for deferrals (Code Y)• Application of the income inclusion and additional tax

provisions• Funding restrictions under §409A(b)


Arrangements Commonly Subject to § 409A

• Nonqualified Deferral Arrangements (elective or not)• Mirror 401(k)• Some 457(f) Plans• SERPs• Stock-Based Arrangements

• Except restricted stock and NQSOs/SARs (“stock rights’) if granted at FMV with no post-exercise deferral features

• Annual and Long-Term Bonuses (2-1/2 month rule exception)

• Severance Arrangements (with exceptions)• Employment Agreements • Taxable Reimbursements (with exceptions)


Scope of Section 409A

• A deferral of compensation occurs…• If an employee or other service provider has a “legally

binding right” during a year to receive compensation that under terms of the plan is or may be payable in a later year.

• May be deferred compensation even if legally binding right is conditional (but required future services affect)

• A deferral may occur even if there is a substantial risk of forfeiture (i.e., vesting requirements).

• Statutory exemptions• Exemptions under Treasury Regulations


Scope – Grandfathered Amounts

• Amounts earned and vested as of 12/31/04, under a plan in effect on 10/3/04 are grandfathered, provided that the plan is not materially modified

• Examples of what are not material modifications in final regulations

• Inadvertent amendment materially modifying a plan can be rescinded within the year


Scope – Short Term Deferrals

Exemption from Deferred Compensation Definition for Short-Term Deferrals

• Generally applies if payment made by March 15 of year following year of vesting

• Does not apply if the payment triggered on event that may occur outside the 2 ½ month window (e.g., upon separation)

• Removes many arrangements from 409A


Traditional Deferred Compensation Programs

• Deferred Compensation Means: A legally binding right to compensation that arises in one taxable year, with actual or constructive receipt of the compensation in a subsequent year– Employee is vested in compensation in one year that

will be paid to him in a future year– May include a contingent right (e.g., service periods,

performance targets)• Typical Plans

– Elective Deferral Plan– Excess Benefit Plans– Supplemental Executive Retirement Plans (SERPs)


Types of Deferred Compensation Plans

• Elective Deferral Plan – Employee defers own money– May include employer incentive such as a

match or discretionary contribution• Excess Benefit Plans

– Generally applies to income amounts in excess of 401(a)(17) and 402(g) limits for qualified plans

– Defined Contribution or Defined Benefit


Excess Benefit Plans

• Generally applies to benefits based on income amounts in excess of 401(a)(17) and 402(g) limits for qualified plans

• Excess defined contribution plans– All benefits are subject to 409A– Time and form of distribution may be automatic (no employee

election)• Excess defined benefit plans

– All benefits are subject to Section 409A– May offset qualified plans limited benefits– Time and form of distribution cannot be tied to time and form

under the qualified plan (i.e., cannot have “linked” payment dates)

– Distribution date typically later of termination or specified age


SERPs

• Supplemental Executive Retirement Plans– All benefits are subject to 409A– May be similar to qualified defined benefit plans– Distribution date typically later of termination or specified age – If offset by other deferred compensation plans, the time and form

of payment must match


Deferral Elections

• Timing of deferral elections– General rule

– Election must be made before the 1st day of the year in which services are performed.

– If a plan does not provide for an election, election will be deemed made pursuant to terms of plan.

– Performance-based compensation.– If based on services performed over period of at least 12

months, election must be made no later than six months before end of performance period.

– First year of eligibility.– Within 30 days of first becoming eligible.


Scope – Severance Plan Exemption

• Exemption for certain payments on involuntary termination or pursuant to a “window plan” made by end of second year after year of separation• Payments up to 2 times annual compensation• Maximum amount of compensation is the §401(a)(17)

compensation limit ($265,000 in 2016 for a total limit of $530,000)

• Rebuttable presumption as to involuntary or voluntary separation based on documentation• Mere fact that separation is “papered” as voluntary not

dispositive


Short-Term Deferrals and Severance

• Severance payments may also be exempt under short-term deferral exception

• Severance not exempt under short-term deferral may still be exempt under severance plan exemption, meaning exemptions may be “stacked” to increase exempt severance amounts

• Often a key issue for severance payable to “specified employees” subject to six-month delay requirement, as exempt amounts need not be delayed for the six months


Good Reason Termination Provisions

• Treasury Regulations treat qualifying “good reason” termination under plan or agreement terms as involuntary for purposes of short-term deferral and severance plan exemptions

• Safe harbor definition provided under Treasury Regulations, but existing definitions under plans and agreements often deviate from safe harbor

• General “facts and circumstances” rule takes into account “material negative change” in working conditions, existence of “notice and cure” provision, severance amount, etc.


Scope – Post-Employment Reimbursements

• Certain benefits paid for “limited time” after termination of employment are exempt• Incurred by the end of the second calendar year after

the year of termination, with reimbursement made by the end of third year after year of termination

• Types of benefits – Moving, relocation, outplacement• Taxable reimbursements of medical expenses exempt if

provided only during period employee entitled to COBRA • Other de minimis payments up to §402(g) amount

($18,000 in 2016)• Final regulations describe how to structure non-exempt

reimbursements to comply (e.g., tax gross-ups)


Scope – Equity-Based Awards• Restricted Stock – Exempt (property rather than deferred compensation)

• ISOs and Section 423 ESPPs – Exempt• Nonqualified Stock Options & SARs (“stock rights”) -- Exempt if:• Exercise price not less than FMV at date of grant• No feature for deferral of compensation• Number of rights are fixed at grant date• Granted on “service recipient stock”• Not modified

- If not exempt, likely violate 409A


Scope – Modification of Stock Rights

• A modification to a stock right is considered to be a grant of a new stock right

• The modified stock right may be subject to 409A as of the original grant date if it is in the money when modified

• The following are not modifications– Shortening period during which a stock right is exercisable.– Addition of a feature providing for ability to tender previously

acquired stock, or withholding of stock from exercise of the stock right, for purposes of paying exercise price, employment taxes or withholding taxes.

– Exercise by plan administrator of discretion specifically reserved under stock right with respect to transferability of stock right.


Scope – Modification of Stock Rights (2)

• Extending exercise period will not cause an option to be subject to 409A if extended period does not end after the end of original maximum term of option or, if shorter, 10 years from option grant date.

• Repriced stock rights are treated as new grants, but are not subject to 409A if exercise price is not less than FMV (i.e.. not "in the money") at the time of repricing/re-grant.


Scope – Restricted Stock Units

• RSUs (“phantom shares”) are not property and have no special exemption from 409A

• Often fit in short-term deferral exemption• Need to pay out on vesting• Vesting on retirement features problematic• Performance-based awards

• If not exempt under STD rule, distributions need to comply with 409A rules


Dividend Equivalents

• Dividend equivalents generally best addressed as a separate grant

• If automatically granted with respect to RSUs or other equity grant that is deferred compensation, the agreement should specify that dividend equivalents are paid at same time and in same form as related equity

• Avoid administrative errors


Common Pitfalls in Equity Awards• Too much discretion in equity plan (e.g.

extending vesting period or adding vesting requirement) can result in impermissible deferral, especially delaying vesting for RSUs, PRSUs or other equity awards (i.e., non stock-rights)

• Failure to award options at or above FMV on the date of grant (common problem with private companies)

• Multiple repricings of stock rights


Distribution Rules

• Payments must be made upon:– A fixed date or a fixed schedule– Occurrence of the following events:

• Separation from service• Six-month delay at public companies• Death• Disability• Change in control• Unforeseeable emergency


Key Employee 6 month limitation

– Applies to top-50 officers of public company (including companies listed outside U.S.)

– Distributions of deferred compensation to a "specified employee" on account of separation from service may not be made within six months after termination of employment

– Specified employees are designated on December 31 of each year and are treated as specified employees for the 12-month period commencing on April 1 of the following year

– May designate a date other than April 1– Separation Pay Exception

– Payments of up to lesser of (i) two times 401(a)(17) limit (i.e., $500,000 for 2012) or (ii) two times annual compensation upon involuntary separation from service are excluded from six-month limitation


Distribution Rules

• Prohibition on Acceleration• Exceptions

– Certain plan terminations– Domestic relations order– Cancellation of deferral election due to disability or

unforeseeable emergency– Compliance with conflict of interest or ethics rules– Minimum cash out (up to 402(g) limit)– Taxes (e.g., 457(f) or FICA)


Documentary Compliance• Written terms can be in one or more documents• At time amount is deferred, plan document must

specify amount ultimately to be paid and time and form of payment

• Document must set forth conditions under which deferral elections and subsequent deferrals may be made

• 6-month delay rule must be included for public companies

• Document need not set forth conditions upon which permitted accelerated payments will be made

• “§409A savings clause” while sometimes useful will not cure plainly non-compliant plan provisions


409A Error?– Common Situations

• Distributions– Paid too soon – Paid too late

• Deferrals– Deferred too much– Deferred too little


General Approach to Potential 409A Errors

• Do I really have a 409A error?• If yes, can I fix it under an IRS program?• If I can’t fix it under an IRS program, now

what?


IRS Operational Correction Program

• Can fix certain errors that occurred in current year and two prior years

• No relief for pre-2014 errors now• More recent the error, easier the fix• Less flexibility for insiders• Generally, whichever party has too much money

needs to pay excess to other party• Must take reasonable steps to avoid recurrence


IRS Operational Correction Program

• Mechanical rules, not general correction principles

• No IRS approval of correction – self-correction• But filings with annual tax returns for both

company and executive usually• No prohibition on grossing-up executive for

penalties or costs incurred• Not available if under IRS examination• Must be inadvertent and unintentional error• Tax return disclosures required


IRS Documentary Correction Program

• IRS Notice 2010-6 provides opportunity to fix noncompliant or impermissible provisions

• Tail risk for offending provisions triggered within one year of fix

• Not all provisions fixable– payment form/timing linked to qualified plan elections– “bad” stock options or SARs

• Tax return disclosures required


Other Issues To Consider

• Conditions to payments: contingent rights and impact on timing– Releases

• When deferred compensation payment is contingent on execution and irrevocability of a release, the agreement should provide a fixed date or window period for payment following execution of the release.

• Fixed Date: e.g.; payment on the 60th day after termination of employment

– Practical problem: an employee who signs the release immediately after termination still has to wait until the fixed date to begin receiving his severance

– Return of Company Property requirements

Nuts & Bolts of Section 409A: Practical Issues to Consider ... · Nuts & Bolts of Section 409A:...

Documents

Transcript of Nuts & Bolts of Section 409A: Practical Issues to Consider ... · Nuts & Bolts of Section 409A:...