Deadline Approaching for Making 409-Related Amendments to Compensation Arrangements

The rules relating to deferred compensation changed dramatically when the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Section 409A applies to deferred compensation arrangements between companies and employees, directors and/or independent contractors (collectively “service providers”). This Alert is a reminder to clients of the importance of reviewing all compensation arrangements and, if necessary to avoid Section 409A violations, amending such arrangements prior to the December 31, 2008 deadline. Previous Goodwin Procter Client Alerts covering Section 409A in more detail are available here.

Section 409A’s scope is exceedingly broad. Its application is not limited to public companies, arrangements with senior executives and traditional deferred compensation plans. Section 409A applies to all deferred compensation arrangements with any service provider unless the arrangement is specifically exempt from coverage. A deferred compensation arrangement is any arrangement where a service provider is deemed to have earned a right to compensation and when the payment of that compensation may not occur until a subsequent tax year. Deferred compensation arrangements take many forms, including those that a company might not typically think of as “deferred compensation.”  For example, garden variety employment documents such as offer letters with severance terms, employment agreements, bonus programs and severance policies are all potentially subject to Section 409A. More traditional deferred compensation arrangements such as elective deferred compensation plans, SERPs, change in control agreements, discounted stock options and deferred or restricted stock units are subject to Section 409A as well. 

Among other things, the IRS’s Final Regulations to Section 409A, which become effective on January 1, 2009, provide that once a service provider earns a right to receive deferred compensation pursuant to an offer letter, employment agreement or bonus arrangement, the service provider is deemed to have made an “election to defer compensation.”  Once an election has been made, there are significant restrictions on the ability to change the timing and form of payment. If the timing and form of payment do not comply with the requirements of the Final Regulations, the company will have tax reporting obligations, and the service provider will be subject to a 20% excise tax on the deferred compensation as well as incur other significant tax consequences. However, if the deferred compensation arrangement has been drafted or amended prior to the deadline to make the arrangement exempt from Section 409A and/or comply with the Final Regulations, those adverse tax consequences can be avoided.

As addressed in previous Goodwin Procter Client Alerts, the IRS has provided companies with a lengthy transition period to amend their existing deferred compensation arrangements. This transition period ends on December 31, 2008. Therefore, it is strongly recommend that, in addition to traditional deferred compensation arrangements, all offer letters with severance provisions, employment agreements and bonus arrangements, be reviewed as soon as possible to determine whether compensation payable under such arrangements is subject to or exempt from Section 409A coverage. The following are examples of potentially problematic terms that frequently appear in standard employment documents:   

• a service provider has a right to receive severance if he or she terminates the working relationship for “good reason” and the good reason definition is broader than the safe harbor definition articulated by the IRS in the Final Regulations;
• a service provider has a right to receive severance pay in the event the company elects not to renew a term employment agreement;
• a severance right is triggered if the service provider’s employment is terminated as a result of the service provider becoming disabled;
• the company has an ability to pay a service provider earned bonus compensation later than March 15 of the year following the year in which services were performed;
• the service provider has a right to receive compensation upon a “change in control” and the change in control definition is broader than the definition approved by the IRS through its Final Regulations;
• a service provider’s severance payments are conditioned on a release of claims and the timing of the severance pay is tied to the effective date of the release;
• the severance agreement does not include a provision mandating a six-month delay after separation from service for payment of severance pay to “specified employees” of companies that are or may become publicly traded;
• the arrangement fails to specify the form of payment (lump sum or installments) or allows for a later election as to the form or timing of payments; and/or
• the service provider or the company has the ability to accelerate payments.

In sum, Section 409A requires more specificity in deferred compensation arrangements. Also, business judgments need to be made about whether to amend existing arrangements to be exempt from Section 409A or, alternatively, to make less material changes that will cause the deferred compensation arrangement to comply with Section 409A. While both methods accomplish the tax goals, Section 409A does not permit deferred compensation arrangements that merely comply with its regulations to be restructured or renegotiated after the transition period ends. This restriction can be significant since, as a practical matter, parties often want to negotiate a new or different separation arrangement at the time of termination of employment.

The time frame to address Section 409A issues is now extremely limited. Goodwin Procter would be pleased to assist in any review and, if necessary, craft appropriate amendments. Given the impending deadline and the number of compensation arrangements potentially covered by Section 409A, we request that you provide compensation arrangements to us on or before November 30, 2008.  Please also keep in mind that any necessary amendments would likely require compensation committee or board approval prior to the deadline. As noted above, the deadline for Section 409A documentary compliance is December 31, 2008.