Escaping the Clutches of 409A

by Pullman & Comley, LLC

Employers often use non-qualified deferred compensation (“NQDC”) arrangements to motivate or reward executive and management employees. These NQDC arrangements, if properly structured, enable key employees to defer income taxes and supplement benefits that will be payable to them under tax-qualified retirement plans. The enactment of Internal Revenue Code Section 409A (“409A”) in 2004, introduced a heightened level of regulatory oversight and significant negative tax consequences to the NQDC world. Since 2004, when considering whether and how to provide NQDC to key employees, the primary concern is whether it will be subject to 409A and its onerous noncompliance sanctions.

What is Deferred Compensation under 409A?

409A and its regulations define deferred compensation broadly to mean any compensation earned in one taxable year but paid in another taxable year,[1] causing many common bonus and severance arrangements seemingly to fall within this definition. The 409A regulations, however, address the overly broad nature of the definition by identifying certain arrangements as not being subject to 409A[2]. In order to create greater flexibility, many employers try to structure NQDC arrangements to come within one of the exceptions created by the 409A regulations. One of the most used exceptions is the short-term deferral exception.

What is the Short-Term Deferral Exception?

The Short-Term Deferral Exception relies on payment occurring within an “Applicable Payment Period.” Generally, where the payer and recipient of the NQDC are calendar year taxpayers, the Applicable Payment Period ends on March 15th of the year following the year when the recipient earns the NQDC. If the NQDC is paid within the Applicable Payment Period, the arrangement is not subject to 409A.

For example, Employer Z awards a bonus to Employee A on November 1, 2013. On the date of the award, Employee A does not need to perform any additional services in order to get the bonus. As long as the bonus is actually paid to him no later than March 15, 2014, the bonus payment will come within the short-term deferral exception. This example, taken from the 409A regulations, shows that the short term deferral exception will apply even when the document creating the NQDC does not explicitly state a specific payment date. The key under this example is that the bonus is actually paid within the Applicable Payment Period (i.e. by March 15, 2014).

The short-term deferral exception will be lost, however, if a plan, agreement or arrangement creates the possibility that the NQDC will be paid outside the Applicable Payment Period even if the NQDC is actually paid within the Applicable Payment Period. For example, assume our Employee A has the same bonus award but the award provides that it will be paid in a lump sum upon Employee A’s termination of employment. Since Employee A could terminate employment after March 15, 2014, the bonus arrangement is now subject to 409A.

Will a Release Negate the Short-Term Deferral Exception?

Sometimes employers condition the payment of NQDC on the employee executing a general release of all claims against the employer, especially where the NQDC is severance pay. These releases generally create a period for consideration of the terms of the release (typically 21-45 days, depending on the situation) and a seven-day revocation period following the execution of the release. The NQDC is only paid after the revocation period has ended. Can this typical release negate the short-term deferral exception? The answer is: maybe.

As indicated above, for purposes of preserving the short-term deferral exception, it is not necessary for a plan to state a specific payment date for the NQDC, as long as it is actually paid during the Applicable Payment Period. A release with no firm date by which it must be signed should be fine, as long as the NQDC is paid during the Application Payment Period. Nonetheless, in the absence of a requirement in the plan or agreement that the release be signed on a date allowing the payment of NQDC within the Applicable Payment Period, an argument can be made that the short-term deferral exception never applied to the plan. Additionally, if a release is, in fact, delayed so that payment is after the end of the Applicable Payment Period, serious compliance issues under 409A are triggered.

Since we do not have clear guidance on this issue, the better practice is to require releases to be executed within a time period that results in payment within the Applicable Payment Period. For example, a severance agreement can provide that the release be executed no later than 60 days following the date employment terminates and that payment will be made no later than the last day of the Applicable Payment Period. Some agreements go a step further and provide that the NQDC will be forfeited if the release is not signed within the specified period. This last approach will definitely keep the NQDC out of 409A but it may not always be practical.

If the nature of the business transaction giving rise to the NQDC does not permit a release with a deadline, the parties need to be careful to make sure that the release is executed in a timely fashion, allowing the NQDC to actually be paid within the Applicable Payment Period. The 409A regulations do contemplate circumstances that could cause a payment of NQDC to be made outside the Applicable Payment Period while still preserving the short-term deferral exception. An unforeseeable administrative impracticability is one such circumstance. Unfortunately, delayed releases generally do not fall into this category. The best way to avoid uncertainty and 409A when requiring a release before paying NQDC is to set a specific date for the execution of the release in the plan or agreement creating the NQDC.

[1] Treas. Reg. 1.409A-1(b)(1)

[2] Tax-qualified plans, 403(b) and eligible 457(b) plans, and bona fide disability pay are examples of excluded arrangements.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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