Publications
Updated to reflect issuance of IRS Notice 2007-86, October, 22, 2007.
One of the less obvious consequences of the Enron collapse was to spark a renewed interest in Congress to regulate deferred compensation. Congress was angered because Enron executives who were aware of the company’s impending bankruptcy were able to jump ship with their golden parachutes intact. In response, Congress enacted Section 409A of the Internal Revenue Code. In short, Section 409A accelerates the recognition of income that would otherwise be deferred to a later year, and it imposes a 20% tax penalty on that income, unless certain requirements are met, or certain exemptions apply.
You might assume that Section 409A is inapplicable to executive employment agreements, since it regulates only non-qualified deferred compensation plans. However, the IRS regulations implementing Section 409A make clear that Section 409A covers many arrangements that do not sound like non-qualified deferred compensation plans, including employment and consulting agreements, and severance agreements. Consequently, executives who have employment, consulting or other agreements that provide for severance must take steps now to ensure that the agreements are exempt from Section 409A or meet the requirements of Section 409A.
Section 409A mandates that non-qualified deferred compensation plans be in writing. Under final regulations issued earlier this year, the deadline for making plan documents compliant with Section 409A (or taking necessary steps to make them exempt) was December 31, 2007. However, in a recently issued release, the IRS has extended the deadline for documentary compliance to December 31, 2008.
Readers should note, however, that Section 409A has already become effective, and that employers who have employment or other agreements that include severance arrangements, or other non-qualified deferred compensation plans in place, must operate them in “good faith” compliance with the requirements of Section 409A, regardless of whether they have amended the written plan documents or not. In addition, as noted below, there are certain opportunities to ensure that a severance arrangement will qualify for an exemption from Section 409A that require action before the end of 2008.
One potential trap that looms large for executives with employment contracts relates to severance payments that are triggered by the executive’s resignation for “good reason” as defined in the agreement. Many executive employment contracts provide the executive with the right to resign and receive a severance payment if the employer takes certain actions short of termination (i.e. material reduction in salary or responsibilities). The IRS, when drafting regulations to implement Section 409A, initially took the position that such severance payments were vested rights since, in the view of the IRS, the executive retained control over the right to receive such payment (i.e. the executive could trigger the payment of the severance benefit merely by resigning).
This treatment was problematic for executives, because it meant that the employment contract granting such severance payments constituted a non-qualified deferred compensation plan subject to Section 409A.
In contrast, the draft IRS regulations treated severance payments that were triggered only by the involuntary termination of the executive (as opposed to a resignation for “good reason”) as being non-vested rights which might qualify for an exemption from Section 409A. The IRS was comfortable with making an exemption available for properly structured severance payments that were triggered only by the involuntary termination of the executive, since that event was deemed to be beyond the executive’s control.
The final regulations implementing Section 409A take a more reasonable middle ground, and permit a properly crafted severance arrangement to qualify as exempt from Section 409A, even though it contains a provision triggering severance payments upon the executive’s resignation for “good reason.” The final regulations allow an executive’s resignation for “good reason” to be treated as an involuntary termination for purposes of Section 409A if the facts and circumstances support a determination that the voluntary resignation was the functional equivalent of an involuntary termination; or the definition of “good reason” contained in the employment or severance contract complies with a safe-harbor test set forth in the regulations.
The facts and circumstances test is essentially a backward looking review of the circumstances leading to the executive’s departure. In essence, the IRS will look to see if the resignation was forced on the executive as a result of a significant change in the executive’s conditions of employment that was tantamount to being fired. Relevant factors would likely include things like a material reduction in the executive’s authority, a material reduction in the employee’s salary and benefits, or a mandatory relocation to a job site far from where the executive is currently located.
The IRS would also look closely to determine whether there was collusion between the employer and the executive to engineer a “sham transaction” which looked like the equivalent of an involuntary termination, but was really a mutually agreed upon arrangement that was done largely for purposes of avoiding the application of Section 409A.
The safe harbor requires that the definition of “good reason” for resignation be limited to one or more of the following objective factors:
- A material diminution of base salary;
- A material diminution in the employee’s authority, duties or responsibilities;
- A material diminution in the authority, duties or responsibilities of the supervisor to whom the employee is required to report, including a requirement that an employee report to a corporate officer or employee instead of directly to the board of directors;
- A material diminution in the budget over which the employee retains authority;
- A material change in geographic location at which the employee must perform the services; or
- Any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.
In addition, to qualify for the safe harbor, three additional conditions must be met:
- The severance payable upon an executive’s resignation for “good reason” may be paid only if the executive actually terminates employment within a limited period of time not to exceed two years following the initial existence of the “good reason” for resignation;
- The amount, time and form (i.e. lump-sum or installments) of severance payable upon a resignation for “good reason” must be the same as would be provided if the executive was terminated by the employer without cause; and
- The executive must provide notice to the employer of the occurrence of “good reason” for resignation within 90 days of the initial existence of such reason, and the employer must be given 30 days to remedy the situation.
While an executive may, ultimately, be able to rely on the facts and circumstances to support a finding that the resignation for “good reason” was comparable to an involuntary termination, this is not the recommended approach. To ensure the desired tax treatment, the executive should make sure that the employment or severance agreement already includes “good reason” language that meets the safe harbor, or is amended to conform the “good reason” resignation provision to the safe harbor.
In recent guidance, the IRS has stated that modification of a “good reason” resignation provision to conform it to the safe harbor provided in the regulations will be respected by the IRS if the modification is completed by December 31, 2008, and the severance payment that would be triggered as a result of a “good reason” resignation is subject to a substantial risk of forfeiture under the facts and circumstances test. Thus, the IRS has provided a narrow window of opportunity to add safe harbor language that will ensure treatment of a “good reason” resignation as an involuntary termination.
While compliance with the safe harbor language is (absent reliance on the facts and circumstances test) a necessary condition to qualifying for an exemption from Section 409A, it is not the only condition that must be satisfied. Compliance with the safe harbor test will ensure that a “good reason” resignation is treated as an involuntary termination for purposes of Section 409A, but certain other conditions must be met to qualify for the exemptions related payments made as a result of an involuntary termination. For example, each of the applicable exemptions requires payments to be made within certain time periods; and certain of the applicable exemptions impose limits on the amount of compensation that can be paid under those exemptions.
Likewise, there are certain requirements pertaining to specified employees of public companies that must be met. A discussion of those additional exemption requirements is beyond the scope of this article. In addition, it is worth noting that the regulations implementing Section 409A provide detailed requirements concerning what constitutes a bona fide separation from service. An executive should be careful to make sure not to run afoul of these regulations, which can often treat the termination of an executive followed by retention of the executive as a consultant or in another alternate capacity as negating the separation from service.
Dodd Griffith is a shareholder, director and Secretary of the law firm of Gallagher, Callahan & Gartrell, P.C., a regional law firm with offices in Concord, New Hampshire; Boston, Massachusetts and Augusta, Maine. He serves as the practice group leader for its Corporate, Finance and Tax Practice.
* Dodd Griffith is admitted in New Hampshire.