In November, Priori attorney Sandra Cohen led a roundtable discussion for in-house counsel on trends in executive compensation agreements. Some of her thoughts on 409A are below:
Plans that are subject to 409A vs. Plans that are exempt from 409A:
- Plans are subject to Section 409A of the Internal Revenue Code if the payment is made, or could be made, in a calendar year later than the year in which the awards vest (or in 409A-speak, the year awards become “no longer subject to a substantial risk of forfeiture.”) Any forfeiture risk due to a non-compete or similar covenant is ignored under 409A – it’s not considered a “substantial” risk of forfeiture.
- Plans are exempt from 409A if the payment must always be made in the same calendar year as vesting, or within 2 ½ months after the end of that year. An RSU or PSU Plan could be exempt from 409A (no deferral), depending on the special vesting features of the Plan. There are other exemptions from 409A, but this is the most common one.
What is the impact of including a retirement privilege?
- If the Plan terms waive forfeiture for a participant upon retirement (or other event) in such a manner that the participant no longer has to continue to perform significant services until the payment date, this provision causes the affected participant’s award to become subject to 409A, instead of exempt.
- This applies to anyone who could become eligible for the privilege under an award, even if the person never actually retires or ceases to perform significant services during the deferral period.
If a Plan is subject to 409A, what are the compliance rules?
- If a plan is subject to 409A, then it must comply with the restrictive tax rules. In very summary form: the basic tax rule is that there must be a pre-determined, permitted event for payment for all “deferred compensation”. Payment may only be made on a fixed date or another permitted payment event. No delays or accelerations of payments are allowed, with a few minor exceptions.
- “Separation from Service” is a permitted event, but key officers will be subject to a required six-month delay on termination.
- Death, Disability, Unforeseen Emergency and Change in Control are also permitted payment events.
Where payment terms could comply with 409A, what are the negative consequences of being subject to 409A?
- Reduced flexibility – Plan can no longer pay early or delay payment, or substitute for a different award.
- Some changes to the Plan text would be necessary: Re-evaluating certain Plan definitions, limiting somewhat the discretion, and most importantly: adding a six-month delay for key officers if there are any payouts upon termination, including without Cause terminations. The six-month delay is required to be written into the Plan text (this is often a trap for the unwary). You can limit the effect of the necessary Plan language to just U.S. taxpayers, or apply the rules to everyone.
- Administrative reporting obligations, to report the amount deferred as of Dec 31, each year, on Form W-2. This is applicable for U.S.-based employees. However, the rules are currently suspended pending new IRS guidance. It’s reasonable to interpret the rules as not requiring W-2s for U.S. citizens working in Canada or other countries where you don’t currently issue Form W-2.
- Mistakes are expensive – if the Plan is subject to Section 409A, but fails to comply with the rules, participant would be subject to early income inclusion, a 20% additional tax, plus interest. Furthermore, all similar plans are aggregated for purposes of this penalty, even if the other plans are compliant!
Final word: Don't confuse "being subject to Section 409A" with "failing Section 409A." It's best to be exempt from Section 409A, but if your plan can't be exempt, then it should be good enough to comply with the Section 409A rules to avoid a penalty on the participants.