25 Sep Common 409A Errors in Employment Agreements
Section 409A has been in place since January 1, 2005, however we still often see employment agreements that do not comply with the rules. This article discusses five of the most common Section 409A errors that we see in employment agreements.
Section 409A imposes restrictions on the payment of deferred compensation, which is generally compensation earned in one year and payable in a different year. Payments of deferred compensation must satisfy the requirements of Section 409A and the applicable regulations, or the payments will be immediately taxable, and subject to a penalty of 20% on the amount of the compensation together with an interest charge calculated on the tax deferred. The penalties and interest are imposed on the employee, however employers may end up paying if there are indemnification procedures in place or to avoid upsetting the employee.
To satisfy the Section 409A requirements, the deferred compensation agreement must be put in writing in the year the compensation was earned, and the agreement must specify the date on which payment is to occur or a specified event that will trigger the payment. Once the agreement is in place, there are restrictions on advancing payments.
The requirements sound straightforward, but in practice a number of problem areas have arisen, usually concerning discretion
as to the timing of the payments.
Common Section 409A Mistakes
Payment Periods Longer than 90 Days
Some deferred compensation agreements give the employer a fixed period of time to make the payment following the triggering
event. This period of time could cross multiple tax years and therefore the employer has discretion as to the tax year in which the employee receives the payment. This level of discretion is a problem under Section 409A because of concerns that the employee will influence the timing of the payment.
The regulations include a “90-day rule” that prevents the use of employee discretion regarding the timing of the payment. Under the regulations, payments of deferred compensation must be paid in a fixed taxable year, within a period of time that does not cover multiple taxable years, or within a 90-day period that does cover multiple years, as long as the employee has no right to designate the year of payment.
Severance Payments Conditional on Employment Claims Release
Under the 90-day rule discussed above, the employee must not have the right to designate the year of payment. This can create a problem where employers agree to generous severance packages for high-level employees, but condition the payment on the employee agreeing to waive all employment claims that he or she may have against the employer. A clause of this nature may give the employee the opportunity to choose the year of the payment by returning the claims release form in the desired taxable year.
If the employer wants to include an employment claims release clause, the clause should state that if the payment can be made in different tax years dependent on when the employee signs the release, the payment will automatically be paid in the later tax year.
We often see plans for the reimbursement of taxable expenses that are not compliant with Section 409A, perhaps because
employers do not immediately consider this type of payment to be deferred compensation. Unfortunately reimbursements can, and often do, fall within the broad remit of Section 409A.
A plan for reimbursements must meet the following conditions: (1) the plan includes an objective definition of the type of payments eligible for reimbursement; (2) the plan includes a prescribed period during which reimbursements will be made; (3) the amount of expenses eligible for reimbursement in one taxable year will not affect amounts eligible in other taxable years; (4) payment will be made by the end of the taxable year following the year in which the expense was incurred; and (5) the reimbursement right is not subject to liquidation or exchange for another benefit.
Alternative Forms of Payment
Employment agreements should not include alternative forms of payment after the occurrence of the specified event. For example, a payment payable over 3 years in cases of voluntary termination cannot be payable instantly in cases of
The general rule is that no variation in the form of payment is permitted for each triggering event, however there are some exceptions. If the triggering event is death, disability, change in control, or an unforeseeable emergency, then the form of the payment can vary depending on whether the event occurs before or after a specified date.
If the triggering event is a separation from service then a maximum of three forms of payment can be used. In addition to the standard form of payment applicable on a separation from service, alternative forms can be used as long as they are tied to a separation within two years of a change of control or a separation before (or after) a specified date.
Six Month Rule for Public Companies
Section 409A requires public companies to delay the payment of deferred compensation for six months, if the triggering event is a separation from service and the employee is a “specified employee.” A specified employee is generally one of the “top 50” officers of the company and the controlled group. The controlled group is generally the company and its 80-percent affiliates.
Common mistakes include the omission of the six-month delay language in the contracts of specified employees, and the failure of the controlled group to use a consistent definition of specified employee, as required by the regulations.
The IRS allows employers to correct plans that are not compliant with Section 409A, however penalties will usually apply if a payment is made under the plan within one year of the correction. These penalties can include the application of Section 409A to 50% of the payment. It is therefore important to rectify any mistakes as soon as possible. In addition, all future employment agreements going forward should be reviewed for Section 409A compliance.