Section 409A Update - Winston & Strawn · • How has 409A changed structure, design, behavior generally? • Equity compensation • Stock options still popular, ... Section 409A

© 2013 Winston & Strawn LLP

Section 409A Update November 4, 2013

Michael Falk

© 2013 Winston & Strawn LLP 2

Today’s eLunch Presenter

Michael Falk EBEC Practice Group

Chicago [email protected]

(312) 558-7232


Agenda

• Quick review of Section 409A • Scope

• Rules if Section 409A applies

• Common exemptions from Section 409A

• Game Reset – You Are Here • State of law

• How has 409A changed structure, design, and behavior, in general?

• Correction Guidance and Opportunities • M&A • Best Practices


Quick Review

• Section 409A is intended to force taxpayers to say exactly “when” deferred compensation will be paid • Deferred compensation a contractual promise to pay (credit risk)

• Gov’t felt ability to manipulate timing was abusive

• Section 409A establishes a complicated web of restrictions on “deferred compensation”…BUT

• Scope of deferred compensation is exceptionally broad!


Quick Review (continued)

• How broad is “deferred compensation”? • Any arrangement that promises compensation in a future year, such as

• Salary for employee over the next three years

• Transaction bonus to consultant if Company is sold

• Stock options for director exercisable in the future

• Severance payable upon termination

• Need to develop the 409A mindset • “This arrangement promises future compensation, so it may be subject to 409A. Let’s

determine if it’s exempt. If not, it must comply with all of 409A.”


Quick Review (continued)

• For most companies, Section 409A issues arise in • Employment agreements

• Severance agreements

• Equity and long-term incentive plans

• Nonqualified deferred compensation plans


If Section 409A Applies…

• May/must be paid only upon permissible payment triggers • Specified date

• Death

• “Disability”

• “Unforeseeable Emergency”

• “Change in Control Event” • Note: IPO doesn’t qualify

• “Separation from Service” • Six-month wait for top employees of public companies where separation from service is the trigger

• Several pages define terms above


If Section 409A Applies …(continued)

• Arrangement must state the time (trigger) and form of payment • If participant may designate amount, time, or form of benefit, the election must be made by certain

deadlines • General rule is in calendar year before attributable services commence

• Later election dates allowed for performance-based compensation, new eligibility, etc.

• Once form and trigger identified, the compensation generally cannot be accelerated or further deferred


If Section 409A is violated…

• If an arrangement violates Section 409A (in form or operation) • Participant, not the Company, is subject to

• Immediate income tax to the extent vested

• 20% penalty plus other underpayment penalties

• Company is subject to • Potential reporting/withholding failures

• Egg on face?

• Some correction methods are available • As discussed later…


Exemptions from Section 409A

• Qualified Plans • Certain stock rights (options/SARs)

• No discount; common stock of service recipient or higher entity; no deferral features

• Certain severance pay • Meets conditions and up to certain limits

• Only available for “involuntary” terminations

• “Short-Term Deferrals” • Pay-when-vest arrangements

• “Pay” really by March 15 of calendar year following year of vesting

• “Vest” must be a substantial risk of forfeiture • Continued service through event

• Event related to purpose of compensation that is not substantially certain to occur


Game Reset – You Are Here

• Section 409A is alive and in effect • Violations (form or operation) trigger full wrath of Section 409A penalties unless

corrected under applicable guidance • Section 409A penalties calculated pursuant to proposed regulations

• Still awaiting final regulations

• Chill out, California: • Oct 2013: Reduces its State 20% penalty to 5%


Game Reset – You Are Here (continued)

• 409A experts still among least popular in the room • Documents are longer, with many technical provisions meaningless to lay

people • Uncertainty regarding gray areas and likelihood of enforcement/discovery • Bogeyman (so far) isn’t the IRS, it’s counterpart in corporate transactions


Overall Effect of 409A • How has 409A changed structure, design, behavior generally?

• Traditional nonqualified deferred compensation

• Still popular – newly increased tax rates will only cause more demand • Certain plan features now strategize for 409A

• To avoid hassle of determining “specified employee,” some public co. plans impose six-month wait on everyone

• To maximize distribution flexibility, use five buckets to “ladder” distributions

• Redeferral rules usually require five-year broad jump (move Year 7 distribution to at least Year 12)

• Companies more vigilant about plan operation


Overall Effect of 409A (continued) • How has 409A changed structure, design, behavior generally?

• Employment agreements/severance • Now contain lots of 409A boilerplate

• Specific release timing language

• More conservative definitions of Good Reason/fewer walk-away windows

• Lump-sum severance slightly more common

• Post-employment COBRA or retiree medical less common and approached differently

• 409A indemnity?


Overall Effect of 409A (continued)

• How has 409A changed structure, design, behavior generally? • Equity compensation

• Stock options still popular, but more sensitive for private companies • “Fair Market Value” methods vary for exercise price (geography, ownership)

• RSUs often designed to pay-when-vest • “Retirement” vesting less common, but still out there

• Phantom design often has pimples • If vest before payment, must use 409A “change in control”

• Often frustrating that IPO doesn’t qualify


409A Corrections – General

• IRS has provided correction guidance for both: • Operational errors (Notices 2008-113, 2010-6, & 2010-80)

• Document errors (Notices 2010-6 & 2010-80)

• Many corrections require one-page notice to be attached to both employee’s and company’s next tax returns • Increase audit risk?

• Need good communication among internal groups (HR, Tax, etc.)

• Some companies more hesitant than others to use correction guidance • Look to argue correction guidance not necessary

• Even concede violation in some cases


Good News for Immature and Overripe

• Immature = Not yet vested • Proposed income inclusion regulations give very helpful ability to correct unvested

amounts • Amounts are includible in income and subject to additional 409A taxes in the first year in which

• Amount vests (i.e., no longer subject to “substantial risk of forfeiture”) AND

• Deferred amount is subject to a 409A error (form or operation)


Unvested Amounts (continued)

• May self-correct while unvested • Operational or document problems

• Helpful for discounted options/linked plans

• No need to use formal correction guidance or to attach notices • Can’t abuse it…

• Only used to correct inadvertent errors

• No pattern of using rule to abuse 409A


Unvested Amounts (continued)

• Clearly works when amount remains unvested throughout end of year • What if vests later that same year?

• Extend vesting or add new SRF? • IRS generally ignores extended vesting unless

• Materially greater amount

• Amounts would otherwise vest upon change in control event

• Often tests one’s risk tolerance for what constitutes a “substantial risk of forfeiture”

• What if partially vested?


Good News for Immature and Overripe

• Overripe = Closed tax years • Proposed income inclusion regs concede that 409A violation in closed tax year is non-

event • Example: Distribution due in 2007 was never made. Violation occurred in 2007 and can be paid

now without 409A problem. Normal income tax applies.


Operational Errors

• IRS Notice 2008-113, modified by 2010-6 and 2010-80 • Can significantly reduce or eliminate 409A tax

• Remember that operational errors aggregate all other similar plans (account, non-account, etc.)

• Most common errors: • Deferring too much or too little

• Payments miscalculated or at wrong time • Regulations give some relief

• Within same calendar year or within 2.5 months, if later

• Calculation is administratively impracticable

• Up to 30 days early

• Disputed payments and settlement of disputes


Operational Errors (continued)

• Correction method depends on • When error (this year, last year, two years ago)?

• After second year, no correction available

• Who? • Non-insiders have more favorable alternatives

• “Insider” is Section 16-type officer or director (applies both to public and private companies)

• How much? • Limited amounts (under 402(g) limit) have more favorable alternatives

• Each correction method carries special rules regarding eligibility and regarding interest and earnings/losses. See Notices for more detail.


Operational Corrections – Same Year

• Correct in same year as failure: • Available for both insiders and non-insiders

• No 409A tax applies

• No notice requirement for employee • Company still must include notice on its tax return


Operational Corrections – Same Year (continued)

• Failure to defer or payment at least one tax year too early • Employee must contribute/repay amount to the plan

• Non-insiders have up to 24 months

• Insiders must pay during that year

• Pay too early within year or violate “six-month delay” rule • Employee must repay amount to the plan

• Payment then delayed beyond original date by number of days employee had the money


Operational Corrections – Same Year (continued)

• Excess Deferral • Plan must distribute

• Stock Rights • If unintentionally discounted, may adjust price up to at least grant-date FMV

• Again, for these same-year corrections… • Available for both insiders and non-insiders


• No notice requirement for employee, but company must include notice on its tax return


Operational Corrections – Next Year

• Correct in following taxable year: • Only for non-insiders


• Notice requirement on tax returns of both employee and company


Operational Corrections – Next Year (continued)

• Failure to defer or payment at least one tax year too early • Repay back to the plan

• Paid too early within year or violated six-month rule • Repay back to the plan and then wait for period equal to number of days by which

original payment was too early


Operational Corrections – Next Year (continued)

• Excess deferral or failure to distribute • Distribute amount from plan

• Stock Rights • If unintentionally discounted, may adjust price up to at least grant-date FMV

• Again, for these next year-corrections… • Only available for non-insiders


• Notice requirement for both employee and company


Operational Corrections – Next Two Years

• Correct within two years following failure: • Available for both insiders and non-insiders

• Additional 20% tax applies on that amount • But no premium interest

• No aggregation of other amounts

• May require amended W-2 and tax return

• Notice requirement on tax returns of both employee and company

• No provision for stock right corrections


Operational Correction Example

• Assume in 2013 a company finds an operational error. Plan was supposed to distribute five separate annual installments beginning in 2011. Hasn’t paid anything yet. • 2015 and 2014 Payments?

• 2013 Payment?

• 2012 Payment?

• 2011 Payment?


Document Errors

• Remember: • No aggregation: document error doesn’t taint similar plans

• “Once deferred comp, always deferred comp”

• Correction Guidance: • Correction allowed only for errors listed in the guidance. No others.

• Stock rights and linked plans generally not correctible

• Similar notice requirements on tax return (company and employee)

• Onerous look-back requirements • Creates suspense! Will there still be 409A tax?

• Alternatives outside correction guidance? • Is it exempt? Then not a “correction”

• General contract provisions?


Document Errors (continued)

• 2010-6 allows informal corrections for minor document problems • No need to do filings. No look-back. Not a violation.

• “As soon as practicable” • No problem as long as it follows a permissible payment trigger (“PPT”)

• Ambiguous definition or no definition • Document complies if savings clause

• No document violation as long as interpreted consistently with PPT



• Bad definitions of otherwise PPT • Amend to correct the definition

• If bad trigger happens within 12 months, then 409A tax applies to some portion of the plan benefit • Bad definition of “separation from service”: 50% subject

• Bad definition of “change in control” or disability: 25%

• Bad payment periods following PPT (too long a period or impermissible employee discretion, such as an unlimited release period) • If fix before PPT occurs, no portion subject to 409A tax

• If fix after PPT occurs, 50% subject to 409A tax



• Multiple triggers: some good PPTs, some bad • Remove bad trigger

• If bad trigger happens within 12 months, 50% subject to 409A tax

• Only bad triggers • Remove all bad triggers and replace with later of separation from service and six-year

anniversary of correction

• 409A tax automatically applies to 50% of the benefit

• Multiple schedules/time form of payment and employee discretion • Amend to eliminate all but the latest

• If triggering event happens within 12 months, 50% subject to 409A tax

• Impermissible Employer discretion to accelerate payment • Amend to eliminate discretion before exercised



• Bad language regarding in-kind benefits • Amend language

• If event that would trigger benefit occurs within 12 months, 50% subject to 409A tax

• Document fails to include six-month delay • Amend before applicable separation from service to provide for payment on later of 18

months following correction or six months from separation from service

• If separation from service occurs within 12 months, 50% subject to 409A tax

• Big help? Any document error can be corrected within first year of new plan.


Audits and Cavity Searches

• IRS audit activity minimal to date • Early Information Document Requests sought information about SRFs and short-term

deferrals • Difficult at times to know whether a plan is subject to Section 409A (that is “we think it’s exempt but

it complies anyway…”)

• Cavity searches occur in corporate transactions • Buyer, lender, etc.

• Valuable to self-audit, categorize and correct or amend documents ahead of transaction rush

• Typical reps/warranties


M&A Issues

• Exempt animals are your friends (great flexibility) • Short-term deferrals

• Stock rights (options)

• Exempt severance

• If substituting stock options, need to comply with 409A rules (e.g., ratio test) • Is there a “change in control” or “separation from service”? • Earn-outs • Special rule allows plan termination upon 409A change in control


Best Practices

• Educate everyone: No compensatory document goes out without 409A review • Adopt an overarching “409A Policies and Procedures” document to fill in gaps • Design for exemption!

• Short-term deferrals, severance exemption, stock rights

• Simplifies corrections and gives more flexibility to eliminate, amend, accelerate, etc.

• Watch out for “Retirement” trap!

• Include change in control as payment trigger or rely on termination rule?


Best Practices (continued)

• If allowing participant elections, dissect election forms to avoid errors • What compensation? (Bonus, annual, plan name)

• New elections affect existing deferrals?

• Complying with deferral timing rules? • Example: really “performance based”/“newly eligible”?

• What if compensation changes during year?

• Preemptively compliant stock options • For private companies

• Does it really change behavior?


Contact Information

Michael Falk EBEC Practice Group

Chicago (312) 558-7232

[email protected]

Buy my book! ◦ Practical Guide to Code Section 409A (CCH, 2012) ◦ Holidays will be here before you know it!


Questions?


Thank You.


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