Section 409A: Regulations Make It Essential To Review Executive Compensation Plans

Editor: The IRS recently issued final regulations under Section 409A of the Internal Revenue Code concerning deferred compensation. What's their impact?

Dorsch: Internal Revenue Code Section 409A was enacted under the American Jobs Creation Act of 2004. Proposed regulations were issued in 2005. Since then, practitioners have been trying to comply, subject to a good faith compliance standard, with Section 409A using the proposed regulations and interim guidance. The final regulations, which take effect January 1, 2008, clarified a number of significant areas and, in general, were more liberal than the proposed regulations. Given the breadth and detail of the regulations, however, companies and executives will find them difficult to navigate.

Pasek: The deadline for compliance with Section 409A and the new regulations is December 31, 2007, so every employer will want to examine its compensation practices for, and agreements with, executive level employees to ensure those employees are not subjected to unanticipated income taxes and penalties. All amendments will need to be in place by December 31, 2007.

Editor: What compensation arrangements are covered by the new rules?

Dorsch: A non-qualified deferred compensation plan includes any form of compensation where an employee obtains a legally binding right to compensation but receipt of payment is deferred to a subsequent year. This means that a number of compensation arrangements, including provisions in employment agreements, change of control agreements, severance agreements, options programs, incentive programs, bonus programs, supplemental executive retirement programs and indemnification provisions may now fall within the ambit of these rules, depending on the program's structure.

Stock options and stock appreciation rights are generally exempt from these rules, so long as such arrangements satisfy a few key requirements. The most significant is that the exercise price has to be at least equal to the fair market value of the underlying stock on the date of grant.

Pasek: Separation pay is also a significant item; the final regulations provide specific exemptions from Section 409A depending on the plan's structure. Specifically, if an executive is involuntarily terminated and the amount of separation pay does not exceed the lesser of two times the employee's annual compensation, or two times the Code Section 401(a)(17) limit ($225,000 for 2007), and the amounts are paid out within two years following termination, the separation agreement will generally not be subject to new rules. So for 2007, the maximum amount of separation pay an executive can receive without being subject to section 409A is $450,000. Any amount of separation pay received in excess of that amount will be subject to Section 409A.

Editor: What documentation does a company need to maintain to comply with the new rules?

Dorsch: Any compensation plan that could fall within the purview of the new rules must be in writing. The final regulations provide that a "savings clause," which ensures that a plan will be administered consistent with Section 409A regardless of provisions to the contrary, will not protect a plan whose terms do not comply with Section 409A. Therefore, it is critical for companies to review these documents and ensure compliance with the new rules.

Pasek: Executives need to examine their employment agreements. If an agreement references any benefits granted through a separate document, it too needs to be reviewed. Even executives who no longer work for a company, but are receiving compensation through a separation agreement, should review those documents and, where necessary, renegotiate or restructure the agreement to the extent possible to avoid the creation of an excise tax. If an executive left after 2004, when the statute went into effect, and expects to receive future payments or non-qualified benefits, it is important to examine those agreements.

Editor: What penalties will apply if compensation agreements are not amended to comply with these requirements?

Dorsch: The penalties and tax consequences are borne by the executives, not the employer. Any executive who receives a benefit under a non-qualified deferred compensation plan that does not comply with Section 409A may be required to include compensation in his current tax return (even if he is not entitled to receive the actual payment until a later date). In addition, the executive will face a 20% excise tax on the amount of non-qualified deferred compensation. Depending on when the Section 409A violation is discovered, the executive may also be subject to interest charges.

Editor: What steps should be taken to ensure compliance with the new rules?

Pasek: Senior executives need to make two calls, one to their executive compensation lawyer and the other to the corporate general counsel. They should ask the corporate counsel to verify the corporation has independently determined and can assure them there will not be an unexpected tax. Their personal lawyers should also review the documents to ensure they can rely on the information provided by the company. Taking these steps is crucial to protect executives from significant adverse consequences.

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