This week we move away from the world of the standard retirement or health and welfare plans and into the world of executive compensation. Executive compensation arrangements provide a company with a highly flexible benefit to further attract and retain top talent. Issues in design and administration of these plans include timing of taxation and whether the plans may be subject to ERISA filing requirements. Below are a few reminders which may help lead to more predictability in operation of a deferred compensation arrangement and reporting requirements.
Code Section 409A: Introduction
Code Section 409A applies to compensation for which the right to payment exists in one taxable year but is payable in a later year. Code Section 409A can also accelerate taxation of payments (meaning the tax is applied at the time the right to the compensation vests but before the amount is paid) and trigger an additional 20 percent penalty tax on the amount involved. Unsurprisingly, many executive compensation practice ‘reminders’ are driven by Code Section 409A compliance.
- Exercise Caution Relying on an Offer Letter
Executive compensation plans providing for deferral of compensation must be in writing. Further, the writing must specify the time and form of payment such that the time it is determinable by being tied to a certain date or to certain specified payment events. Although some companies may document the intent for payments to be made following events, such as separation of service, in the offer letter to the applicable employees, these offer letters will often fail to meet the specificity requirements under Code Section 409A. In cases where offer letters contain non-compliant language and no exemptions apply to Code Section 409A application, the employee may be subject to the tax consequences described above.
- Consult Counsel Before Providing a “Substitute” for a Deferred Compensation Benefit
In attempts to accelerate promised payment to an employee, companies may offer to replace deferred compensation with a new payment on a different schedule. This approach often triggers the burdensome tax consequences under Code Section 409A, as the newly paid or scheduled amounts will be treated as the same preexisting deferred compensation obligation. The result may be an impermissible acceleration which is taxed as such (note, a similar result applies when the new payment schedule is later in time, as well). Whether the new payment is considered a substitution under Code Section 409A is a facts and circumstances approach, but in moments when there is a temptation to allow an employee to forfeit one payment of deferred compensation for a new arrangement, pause, and consult counsel.
- Ensure the Good Reason Definition Complies With 409A
Despite the pitfalls, there are several ways of structuring payments to either be exempt or compliant with Code Section 409A. One exception under Code Section 409A is referred to as the separation pay exception. Under this exception, payments are treated as exempt from Code Section 409A if they are only payable upon an involuntary termination (among other requirements). An involuntary termination under the applicable regulations includes termination for “good reason.” The regulations define good reason narrowly. When “good reason” is defined in a manner inconsistent with the definition under the regulations, the inconsistent (often more liberal) definition can be construed under Code Section 409A as the employee voluntarily terminating employment. The failure to implement the correct definition of “good reason” results in a failure to meet the requirements of the separation pay exception, resulting in significant tax consequences.
Remember the Top Hat Plan Filing
Where an ERISA benefit exists, so may an annual filing obligation. Earlier, we discussed the wrap plan document requirement for filing of Forms 5500 [INSERT LINK IN TEXT TO ARTICLE 1]. Forms 5500 are required to be filed pursuant to Title I of ERISA. This same requirement applies to plans maintained for the purpose of offering a select group of highly compensated individuals welfare or supplemental retirement benefits. However, the plans designed for the purpose of providing benefits to a select group of management or highly compensated individuals may avoid the annual Form 5500 filing requirement in favor of a one-time alternate filing - the top hat filing. This top hat statement must generally be completed through an online platform within 120 days from inception of the plan. Failure to timely submit the top hat statement may lead to needing to retroactively correct the failure by paying a compliance fee or, worse, being subject to hefty Department of Labor penalties for failure to file Forms 5500.
The above is not intended to serve as a complete list of every common concern for executive compensation matters (or tax advice), but is intended to serve as a quick reminder list for plan sponsors.