New rules create potential tax traps for exec compensation

One less obvious consequence of the Enron collapse was the renewed interest in Congress to regulate deferred compensation.

Congress, angered because Enron executives who were aware of the company’s impending bankruptcy were able to jump ship with their golden parachutes intact, 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 percent 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, IRS regulations implementing Section 409A make clear that it covers many arrangements that do not sound like non-qualified deferred compensation plans, including employment and consulting agreements and severance agreements.

Consequently, executives with employment, consulting or other agreements that provide for severance must take steps now to ensure that the agreements are either exempt from or meet the requirements of Section 409A.

Section 409A mandates that non-qualified deferred compensation plans be in writing. The IRS recently extended the deadline for documentary compliance (or taking necessary steps to make them exempt) to Dec. 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, whether they have amended the written plan documents or not.

One potential trap 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 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.

The final regulations take a more reasonable middle ground and 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.

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 also would look closely to determine whether there was collusion between the employer and the executive to engineer a “sham transaction” that 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.

Other conditions

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 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 Dec. 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.

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.

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, a shareholder, director and secretary of the law firm of Gallagher, Callahan & Gartrell, serves as practice group leader for its Corporate, Finance and Tax Practice.