Section 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.

As discussed in our Benefits Bulletin on the new Section 409A rules, 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.

The 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.

Severance 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 requirements:

The 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 available.

The 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).

The benefit is paid by no later than December 31 of the second year following termination of employment.

The final regulations add the following clarifications to the above rules:

1.         “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.

2.         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 following requirements:

The employee must terminate employment within one year following the event constituting good reason.

The amount, time and form of the benefit must be identical to that available in the case of a termination by the employer “without cause.”

The 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.

Good reason must consist of one or more of six specified circumstances that arise without the consent of the employee.

3.         “Good reason” for purposes of the above safe harbor includes the following:

A material reduction in the employee’s compensation.

A material diminution in the employee’s authority, duties or responsibilities.

A material diminution in the authority, duties or responsibilities of the supervisor to whom the employee reports.

A material diminution in the budget over which the employee retains authority.

A material change in geographic location at which the employee is employed.

Any action or inaction by the employer that constitutes a material breach of the applicable employment agreement.

Note 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.

The final regulations also elaborate on the following points which impact Section 409A compliance in general and, specifically, non-competition arrangements providing for deferred payments:

A 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.

The 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.

Required Action:

“Deferred 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.