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Chicago, Illinois 60602
Arrangements Under Section 409A
409A was added to the Internal Revenue Code to govern deferred
compensation arrangements effective with respect to all subject
benefits that vest on or after January 1, 2005. Because of the
broad sweep of Section 409A, almost every arrangement that provides
compensation to executives and other "service providers" payable
in a form other than basic salary should be reviewed for compliance
purposes. Arrangements subject to Section 409A must be amended
to conform with the recently issued final regulations by no later
than the end of this calendar year. A failure to do so will
subject executives covered by such arrangements to unfavorable tax
treatment as of January 1, 2008 (or any later date when a right to
benefits vests) even if the arrangement otherwise operates in
compliance with Section 409A. This means that arrangements
subject to Section 409A must be identified and amended by December
31, 2007. Additionally, operation of subject "deferred
compensation plans" in compliance with a good faith interpretation
of Section 409A is required now and has been since January 1, 2005.
discussed in our Benefits Bulletin on the new Section 409A rules (http://www.benefitslawgroupofchicago.com/HTML/new-deferred-compensation-rules-2005.htm),
all covered compensation arrangements were at that time required to
be amended by December 31, 2006. However, the IRS left several
questions unanswered when prior guidance was issued. These
issues have now been addressed by final regulations issued on April
10, 2007. This bulletin brings you up-to-date on changes and
clarifications of Section 409A, and advises on steps you must take
by the postponed compliance date, December 31, 2007.
final Section 409A regulations provide significant clarification
relating to employment agreements and severance arrangements.
Under prior IRS guidance, it was unclear whether or not termination
for "good reason" would be recognized as an "involuntary"
termination of employment for purposes of the "separation pay"
exemption from Section 409A discussed below. "Good reason"
is frequently included in employment agreements as a trigger for the
payment of severance benefits, and it usually is defined in terms of
a significant reduction in an executive’s authority or duties, a
compensation cutback, or a change in the geographic location of the
executive’s place of employment. The final regulations do
recognize "good reason" (as defined) as an "involuntary"
termination of employment. In effect, if an executive quits
for "good reason," this action on the part of the executive may
reflect a constructive termination of employment by the employer.
arrangements, whether incorporated into employment agreements or
otherwise, are generally subject to Section 409A unless they meet
specific exemptions discussed in the regulations. The most
specific exemption carves out from Section 409A compliance those "separation pay" arrangements which meet the following
benefit is payable only on account of an "involuntary"
termination of employment (or a voluntary termination pursuant
to a "window plan"). If benefits are not conditioned
solely on an involuntary termination of employment (for example,
benefits are payable not only upon termination of employment but
also on account of an "unforeseeable emergency"), the "separation pay" exemption from Section 409A will not be
benefit does not exceed the lesser of two times the employee’s
average annual compensation or the Code Section 401(a)(17) limit
on compensation ($225,000 for 2007).
benefit is paid by no later than December 31 of the second year
following termination of employment.
final regulations add the following clarifications to the above
"Involuntary" termination of employment for this purpose
includes termination for "good reason" by an employee where the "good reason" amounts to a constructive termination of
employment by the employer. Such "good reason" must be
based on conduct by the employer imposing a substantial negative
change in the employment relationship and is evaluated by the IRS on
a facts and circumstances analysis, unless the safe harbor rules set
out below are followed.
The final regulations provide several criteria for a good reason
safe harbor which, if satisfied, will assure that any amounts paid
under the severance arrangement will be considered payable on
account of an "involuntary termination." Any executive
employment agreement that provides the executive a right to
terminate for good reason could be revised in light of these new
safe harbor rules in order to avoid the complication and risk of
Section 409A compliance. The safe harbor criteria include the
employee must terminate employment within one year following the
event constituting good reason.
amount, time and form of the benefit must be identical to that
available in the case of a termination by the employer "without cause."
employee must provide notice to the employer of the existence of
a good reason event within a 90-day period and the employer must
have a 30-day cure period.
reason must consist of one or more of six specified
circumstances that arise without the consent of the employee.
"Good reason" for purposes of the above safe harbor includes the
material reduction in the employee’s compensation.
material diminution in the employee’s authority, duties or
material diminution in the authority, duties or responsibilities
of the supervisor to whom the employee reports.
material diminution in the budget over which the employee
material change in geographic location at which the employee is
action or inaction by the employer that constitutes a material
breach of the applicable employment agreement.
that "change in control" (as defined) is a separate permissible
benefit trigger under Section 409A, but is not itself a basis for a "good reason" termination under the regulations.
final regulations also elaborate on the following points which
impact Section 409A compliance in general and, specifically,
non-competition arrangements providing for deferred payments:
non-compete agreement (an agreement to refrain from performing
services) will not be sufficient to create a substantial risk of
forfeiture for Section 409A purposes. Consequently, a
consulting or other agreement providing for payment of fees
after termination of employment conditioned only on compliance
with a non-compete agreement (in other words, the fees are paid
whether or not any services are actually performed) will cause
all such fees to be fully vested for purposes of Section 409A.
Accordingly, if such an agreement spreads payments over, say, a
three year period, the payments would be deemed fully vested in
the first year and would be taxable in that year along with
Section 409A penalties unless the agreement is Section 409A
compliant or otherwise exempt.
regulations specifically provide that a "savings clause"
will not be effective. The terms of a written arrangement
must conform to the requirements of Section 409A, and a general
provision overriding any non-compliant terms of the arrangement
in the event of a conflict with Section 409A will not be
effective to avoid a violation of Section 409A.
compensation plans" under Section 409A must be amended by the end
of this year. The first step is the identification of subject "plans," which is defined to include contracts with individual
service providers (that is, employees and independent contractors).
Any existing employment agreement or post-retirement consulting
agreement, bonus arrangement, equity incentive plan, and severance
plan as well as any conventional deferred compensation plan should
be reviewed to determine whether it is subject to Section 409A.
If any such arrangement grants a service provider a legally
binding right to compensation that is not currently received but is
payable in a later taxable year, the arrangement will have to comply
with Section 409A or establish an exception to Section 409A
compliance. In either case, changes to the documentation of
the arrangement may be required. For example, employment
agreements may be modified to clearly track the good reason safe
harbor exception for "separation pay" plans discussed above.
Remember, a failure to comply may cause the executives who are the
intended beneficiaries of these arrangements to incur tax penalties
as of January 1, 2008.
Golan & Christie LLP
70 West Madison St.
Chicago, Illinois 60602