Author: Nadia A. Havard
Originally published in October 2020
Copyright © 2020 Knox McLaughlin Gornall & Sennett, P.C.
The word “hidden” as used in the tittle means “not recognized for what it is” in the context of agreements dealing with compensation. As with any other things, the best way to hide is in plain sight. As a result, a lot of agreements dealing with compensation, may contain a provision that, on its face, has nothing to do with deferred compensation.
Section 409A was adopted by the American Jobs Creation Act of 2004 and applies to deferred compensation arrangements as of January 1, 2005. For purposes of Section 409A, deferred compensation, in general, means compensation that is payable in the year after the payee has a legally binding right to it, which is no longer subject to a substantial risk of forfeiture, and which has not been included in income in prior years.
“Substantial risk of forfeiture” for Section 409A means something different from “substantial risk of forfeiture” for purposes of Section 83 (i.e. compensatory transfer of property) or any other provision of the Internal Revenue Code of 1986, as amended (the “Code”). The risk to lose the right to compensation is substantial only if such loss is conditioned on (i) the requirement to perform substantial future services, or (ii) is related to the compensation itself.
What does it mean to be related to the compensation? It means that the employer who pays the compensation should receive the services which it pays for. Alternatively, the compensation can be tied to the employer’s business activities or organizational goals.
How about non-compete clauses? They seem to relate directly to the employer’s business activities.
Here is what the IRS says: Treas. Reg. 1.409A-1(d)(1) specifically provides that “an amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from the performance of services.”
It means that, absent any other provisions required by Section 409A, the agreement which conditions employment termination payments upon the employee not competing for certain time, will give rise to immediate inclusion of income by the employee for the year the agreement is signed. Since the noncompete clauses are not recognized as valid conditions creating substantial risk of forfeiture, the right to compensation becomes legally binding right upon signing the agreement.
On the other hand, Treas. Reg. 1.409A-1(d)(1) provides that the compensation conditioned on ” the attainment of a prescribed level of earnings or equity value or completion of an initial public offering” will be considered as related to the employer’s organizational goals and will create substantial risk of forfeiture.
Here is how executive compensation related to business activities and organizational goals is described in Facebook initial public offering documents filed with SEC:
“Executive Compensation Philosophy, Objectives and Design
Philosophy. We are focused on our mission to make the world more open and connected. We believe that Facebook is at the beginning of this journey and that for us to be successful we must hire and retain people who can continue to develop our strategy, quickly innovate and build new products, bolster the growth of our user base and user engagement, and constantly enhance our business model. [emphasis added] To achieve these objectives, we need a highly talented team comprised of engineering, product, sales, and general and administrative professionals. We also expect our executive team to possess and demonstrate strong leadership and management capabilities.
Objectives.[emphasis added] Our compensation programs for our named executive officers are built to support the following objectives:
Design. As a privately-held company, our executive compensation program [emphasis added] is heavily weighted towards equity, including stock options and restricted stock units (RSUs), with cash compensation that is considerably below market relative to executive compensation at our peer companies.[Emphasis added] We believe that equity compensation offers the best vehicle to focus our executive officers on our mission and the achievement of our long-term strategic and financial objectives and to align our executive officers with the long-term interests of our stockholders.
For our executive officers who received a substantial initial equity award in connection with the commencement of their employment, we have granted additional equity awards with service-based vesting conditions where the commencement of vesting is deferred until a date some years in the future, [emphasis added] […]. When combined with the executives’ initial equity awards, we believe that these additional grants represent a strong long-term retention tool and provide the executive officers with long-term equity incentives. [emphasis added]"
"Elements of Executive Compensation
Our executive officer compensation packages generally include:
We believe that our compensation mix supports our objective of focusing on at-risk compensation having significant financial upside based on company and individual performance. We expect to continue to emphasize equity awards because of the direct link that equity compensation provides between stockholder interests and the interests of our executive officers, thereby motivating our executive officers to focus on increasing our value over the long term. [emphasis added]”
“In the first quarter of 2012, our compensation committee discussed and approved a request by our CEO to reduce his base salary to $1 per year, effective January 1, 2013."
“Mark Zuckerberg. Mr. Zuckerberg received $220,500 for the First Half 2011 bonus, which reflected the impact of his performance in leading our product development efforts, our success in growing Facebook’s global user base and developing developer and commercial relationships. [emphasis added] […]
Sheryl K. Sandberg. Ms. Sandberg received $86,133 for the First Half 2011 bonus, which reflected her contribution to growing revenue, building commercial and developer relationships, growing the Facebook team and excellence in execution in all business-related matters. [emphasis added] […]
David A. Ebersman. Mr. Ebersman received $86,133 for the First Half 2011 bonus, which reflected his contributions in completing our 2010 financial statements, completing our private placement financing, and preparing our financial operations for this offering. [emphasis added] […]”
In order to comply with Section 409A, the written agreement must provide, and indeed, the payments are made only upon a specified date, or according to a specified schedule, or upon the occurrence of events listed by statutes, such as death, disability, separation from service (6 months after separation of a key employee of public companies), a change in ownership or control, or the occurrence of an “unforeseeable emergency”. As a general rule, no acceleration of payments is allowed. Even though the requirements seem to be straight forward, their application might be tricky.
For example, if the agreement states that “the company shall pay the beneficiary of Mr. X (the executive) a death benefit equal to $1,000,000 within 60 days of Mr.X’s death”, the payment period (i.e. within 60 days of Mr. x’s death) is specific enough to meet Section 409A requirements. This agreement complies with Section 409A by fixing the payment period.
Another example relates to permissible acceleration upon death. A contract providing for installment payments over five years upon separation from services and a lump-sum payment upon death, if death occurs prior to separation, is acceptable. Furthermore, under the proposed regulations issued by the IRS in 2016 to the final regulations under Section 409A, installment payments that have already started prior to a beneficiary’s death may be accelerated upon the beneficiary’s death.
The “unforeseeable emergency” includes imminent foreclosure or eviction from the employee’s primary residence, payment of medical expenses, and payment of funeral expenses of a spouse or dependent. The “unforeseeable emergency” does not include either purchase of the home or tuition payment.
As a general rule, elections to voluntarily defer compensation must be made in the year prior to the year in which services are performed. This is true even if the employee is not vested in the deferred amounts.
For example, any elections for deferred compensation for 2021 must be made by December 31, 2020 by the employee who is employed in 2020. Also, unless the election made in 2020 for 2021 compensation is terminated or changed by the executive before December 31 of 2021, it will continue to apply for deferred compensation of 2022.
If the agreement for the deferred compensation is required to comply with Section 409A and fails to meet its requirements (both in writing and operation), deferred compensation becomes subject to taxation plus interest from the date the right to compensation became legally binding (as describe above), plus 20% penalty. Moreover, the IRS will aggregate all nonqualified deferred compensation arrangements of the same type for the same individual for the purpose of applying penalties under Section 409A.
If the compensation arrangement violates Section 409A requirements, any compensation deferred pursuant to the arrangement, will be immediately included in income of the payee regardless of when the actual payment is made. Furthermore, additional taxes will be imposed under Section 409A(a).
In accordance with Prop. Reg. 1.409A-4, each taxable year in which the deferred compensation failed to comply with Section 409A will be reviewed independently, since deferred amounts might have been subject to substantial risk of forfeiture in certain years or might have been included in income during prior years. The taxpayer will be required to include in his/her income the amounts for the year in which the deferred compensation agreement failed to comply with Section 409A.
On the bright sight, an operational failure in one year will not disqualify the amounts deferred in subsequent years. As mentioned above, each year will have to be examined individually. The same is true with regards to the documents as written failing to comply with Section 409A. (If the agreement fails Section 409A in form for a particular year, its failure will not disqualify any subsequent years, provided the failure is corrected.)
It is important to understand when compensation (even if it may be paid at a later time) is not deferred compensation at all. As set forth in Section A above, the employee must have legally binding right to such compensation to begin with. Consider these examples:
Conveniently, as a general rule, payments made within 2 ½ months after the taxable year the right to compensation became legally binding, are NOT subject to Section 409A. They are exempted from being deferred compensation as a short-term deferral.
The short-term deferral rule should not be blindly relied upon. It is easy to miss the difference between a short term payment made pursuant to a written agreement calling for such payment and a short-term payment made solely for convenience purposes. Examples:
The law provides for other useful exemptions from Section 409A. One of them is the exception for severance pay payable upon involuntary termination. (This is a bit misleading, since voluntary termination for good reason as well as voluntary termination under a window program will functionally be treated as involuntary termination.)
So, what does the agreement need to contain in order to meet severance pay exception? The answer is, the agreement must contain the “exception provisions” from Section 409A, which are:
First of all, it is important to determine whether the proposed reimbursement of the expenses is a fringe benefit that is excludable from income under Section 132(a) of the Code. If so, such expense reimbursement is not subject to Section 409A.
If, however, the proposed reimbursement is not excluded from income under Section 132(a) of the Code (e.g. reimbursement of tax return preparation), then further analysis will be required.
Again, like with other payments discussed above, it is important to understand whether the right to have certain expenses being reimbursed is legally binding without substantial risk of forfeiture, and whether the reimbursement will be paid within 2 ½ months after the taxable year the right becomes legally binding. It is irrelevant that the expense (e.g. payment for tax return preparation) has not yet occurred, but the agreement for expense reimbursement has been entered in. Unless the right to have the expense reimbursed is subject to the substantial risk of forfeiture (again, either related to the performance for services for the employer, or the employer’s business activities or organizational goals), the reimbursement agreement must either require the payment within 2 ½ months after the agreement is signed, or comply with Section 409A requirements for deferred compensation.
It is very likely that any reimbursement agreement with the retired or terminated executive will fall within Section 409A.
It can also help if the reimbursement agreement clearly requires the employee to perform services during a year in order to be eligible for reimbursement as well as having the requests for reimbursement submitted no later than 2 ½ months after the expenses have been incurred. If the reimbursement agreement covers a former employee, it must comply with payout requirements (i.e. fixed amount or fixed schedule) imposed by Section 409A as severance pay to cover expenses regardless whether such expenses actually occur.
Indemnification and other contingent pay arrangements that are not covered by Section 132(a) of the Code, and thus, require either exemption from or compliance with Section 409A, include, but not limited to the following:
These arrangements will need to be structured either as short-term deferral payments (i.e. requiring the payout within 2 ½ months from the year end of these expenses occured, provided the employee is employed as of the year end when expenses occurred) or as severance pay.
Caution needs to be taken in modifying or renegotiating existing employment agreements. The payments under the agreement may be subject to Section 409A. Any modification or renegotiation of the agreements that accelerates the payments may violate Section 409A. On the other hand, any further delay of the payments as a result of modification can be considered a second election of deferred compensation subject to the 5-year rule.
Another example from the Facebook initial public offering papers filed with SEC addressing the initial agreement and subsequently amended and restated agreement:
“Retention Bonus. As part of our negotiation of his initial employment arrangement and as an inducement for Mr. Ullyot to become our Vice President and General Counsel, we agreed to pay him an annual retention bonus [emphasis added] in the amount of $400,000 per year for each of his first five years of employment. He will continue to receive this bonus until 2013, pursuant to the terms of his amended and restated employment agreement.”
Even certain compensation arrangements (such as stock options if drafted properly) are outside Section 409A reach, they may, nevertheless, in combination with other compensation agreements, lose their exemption.
For example, the employment contract may allow the executive to extend a period for exercising stock options beyond the original date of exercise which will exceed 10 years from the date the option was granted. Even though the original stock options might have been granted in such a way as to avoid the application of Section 409A, the extension of the period for the option exercise per the employment agreement may be treated as a grant of a new option at the price of the old option. This creates a problem if the current stock price has risen since the old option was granted.
Conveniently, Section 409A excludes certain compensation arrangements as deferred compensation if such compensation arrangements are drafted in compliance with safe harbors and exception provisions of Section 409A.
Here are the examples of what is excluded as deferred compensation under Section 409A:
Stock option agreements will be outside Section 409A per Treas. REg. 1.409A-1(b)((5)(i)(A) if:
For example, the agreement grants the employee a right to purchase 200 shares of stock at $10 each in six years from December 31, 2019. The agreement does not require the employee to be employed at the time of exercise of the option. The agreement also fails to establish how the value of $10 was determined and whether it is adjusted if it is below the FMV upon exercise. The agreement also allows the executive to exercise the option upon change of control in the company. In May of 2022 the company is sold to a third-party buyer. The employee exercises the stock rights and buys 200 shares at $10 each. Since this is a nonstatutory stock option (i.e. issued outside Section 422 statutory stock rights or Section 423 options granted under employee stock purchase plans), and such stock option fails to comply with the exception to Section 409A (by failing to set up FMV as the exercise price was not based on a valuation that meets the requirements of Treasury regulation section 1.409A-1(b)(5)(iv)(B)), and, provided, it does not have any other provisions that brings it under Section 409A compliance, the employee must recognize income equal to the spread between the FMV of 200 shares of stock at vesting (here it is 12/31/2019) less the exercise price (here $2,000) (the year the stock option was granted). Furthermore, the employee must also include in income any additional appreciation as of the end of each subsequent year until the option is exercised, canceled, or otherwise terminated (in this case, year of 2020). The employer must withhold on this current compensation. In addition to being required to include the spread in value in 2019 income, the employee will also be subject to a 20 percent additional income tax on such amounts included in income as a result of the section 409A failure. Finally, if the tax on amounts that fail section 409A (including the additional 20 percent income tax) are not timely paid, the employee may also be subject to a premium interest tax. (The premium interest tax will be based on the underpayment rate plus one percentage point on the underpayment of tax that would have been due had the amount been included in income in the year of vesting, i.e. 2019)
Stock appreciation rights agreements will be outside Section 409A if:
Phantom stock agreement and restricted stock units are forms of equity compensation. Both, the phantom stock and restricted stock units agreements grant an employee the right to receive a fixed amount equal to the value of a specified number of shares. The restricted stock unit agreement provides for payment to be made in actual shares. Phantom stock agreement and restricted stock units must comply with restriction on vesting, transferability, performance of goals and generally require the employee be employed until such rights become mature.
Here is an example of restricted stock unit deferred compensation disclosed by Facebook in their initial public offering papers filed with SEC:
“Equity Compensation. Most of our executive officers’ compensation is delivered through equity awards. We use equity compensation to align our executive officers’ financial interests with those of our stockholders, to attract industry leaders of the highest caliber, and to retain them for the long term. In addition to the equity grant that each executive receives as part of his or her new hire package, the compensation committee has granted our executives additional equity awards in certain of the years after they joined. Additional equity grants for each of our executive officers are determined on a discretionary basis taking into account the following factors:
Based on the foregoing factors, in 2011, our compensation committee awarded each of our executive officers (other than our CEO) a grant of RSUs with a specific “initial equity value” based on an estimated total value for each grant before taking into account the deferred vesting considerations described below. The compensation committee applied discretion in determining the specific individual equity values and deferred vesting start dates. Based on these qualitative decisions, the compensation committee then calculated the exact number of RSUs to be granted by dividing this initial equity value by $20.85 per share, which was the fair value of our Class B common stock as of the end of 2010.
Deferred Vesting of 2011 RSU Grants. The compensation committee deferred the vesting start dates of all 2011 RSU grants made to our executive officers to a future date determined individually for each executive. As a result, the 2011 RSU grants will not begin to vest unless the recipient remains continuously employed by Facebook through future dates as described in “—2011 Grants of Plan-Based Awards Table” below. The compensation committee reviewed the size and vesting schedule for the remaining unvested portion of all outstanding equity award holdings of each of our executive officers and agreed with the recommendation of our CEO and COO (except that our COO did not participate in discussions regarding her own equity compensation) that the existing equity awards appropriately satisfied our retention and incentive goals for the immediate future for each of our executive officers. Accordingly, the additional equity awards granted in 2011 start vesting only after a significant portion of each executive’s outstanding equity awards have vested, and these vesting start dates range from the fourth quarter of 2013 to the fourth quarter of 2014. These grants have four-year vesting schedules that result in vesting end dates ranging from the fourth quarter of 2017 to the fourth quarter of 2018. The compensation committee believes that these vesting schedules make the equity awards more valuable for retaining our executive officers for the long term. For more information relating to the vesting schedules of these RSU grants, see “—2011 Grants of Plan-Based Awards Table” below."
Since the performance based pay is related to the performance of services for the employer or, at least, is tied to the employer’s business activities or organizational goals, the right to performance pay is not legally binding until performance pay requirements are satisfied.
If the performance pay agreement also requires the payment of performance pay compensation (e.g. bonuses) within 2 ½ months after the conditions are met, Section 409A does not apply. However, if the performance pay agreement provides for payment more than 2 ½ months after it is vested (e.g. 36 months after it is vested), the payment is outside the 2 ½ month short-term deferral exception.
For example, the performance based pay agreement states that the bonus for the calendar year 2020 will be paid on December 31, 2023 calculated based on the employee’s performance in 2020. The company actually pays the bonus on March 1, 2021. Even though the bonus is paid within 2 ½ months after December 31, 2020, it impermissibly accelerates the payment. As a result, the bonus must be included in income for 2020 (the year the right to bonus became legally binding) rather than 2021 (when it is actually paid) or 2023 (when it is supposed to be paid under the agreement). Another simple solution would have been to require the employee being employed on December 31, 2023 (the date of bonus payment).
One needs to be aware that regardless how much time it takes to actually determine whether the conditions were satisfied (e.g. the bonus will be paid only if the company division reaches $1,000,000 in sales as of December 31), the performance pay must be paid within 2 ½ months after the year end to satisfy the short term deferral. Otherwise, the performance pay becomes deferred compensation and must meet Section 409A requirements. In this example, if it took the company up to May 1, 2021 to confirm the sales as of December 31, 2020, and the bonus, thus, is paid after May 1, 2021, it is paid too late. It should have been paid by March 15, 2021.
Another example focuses on the performance pay that is conditioned on being employed at the time it is paid. For example if an employee is promised a bonus equal to a percentage of corporate profits received in 2020, which is payable at the end of 2023, provided the employee is employed by the company on December 31, 2023, then the bonus does not vest until December 31, 2023. If the bonus is paid in full when it vests (i.e. December 31, 2023), the bonus is not deferred compensation at all since the right to it is subject to substantial risk of forfeiture. After the right is vested (i.e. December 31, 2023), the bonus is paid. There is no deferral. Even though it is based on 2020 corporate profits and even though it is paid 3 years after 2020 corporate profits are determined.
In theory, parachute payments contingent on a change of ownership or control of employer are outside Section 409A if they are required to be paid out within 2 ½ months of the year when such change occurs. The change of ownership or control is arguably related to the employer’s business activities and constitute a substantial risk of losing such payment. Furthermore, change of control is one of the permissible payout events under Section 409A.
Caution must be taken, however, with regards to defining “change of control” under the agreement. Section 409A(a)(2)(A)(v) and Treas. Reg. Section 1.409A-3(i)(5) define “change of control” as follows:
Here is an example where the agreement failed to define “change of control” as found in Section 409A. The agreement provided that if the executive is terminated prior to change of control, the executive is entitled to receive 18 months severance payable in monthly installments. If, however, the executive is terminated after a change of control, the executive is entitled to receive 36 months severance pay payable in a lump sum. The agreement did not define what “change of control” means. As a result, references to change of control in the agreement became mere indication related to the amounts to be paid, rather than the time of payments. Instead, termination event became the trigger event when the amounts need to be paid. As a result, the agreement, in essence, is re-written to provide that upon termination, the first 18 months of severance are paid in installments and the remainder as a lump sum. Since the executive cannot rely on “change of control” as permissible event for payment, it is crucial to determine whether termination was limited to involuntary or voluntary and whether any payments may qualify for short-term deferral. The worst case scenario is that the agreement failed not only to define “change of control”, but also qualify termination as involuntary only. As such, unless there were other conditions subjecting the right to severance to substantial risk of forfeiture, it must be included in income when the agreement is signed. (And do not forget about additional 20% tax and premium interest.)
As a practical matter, it takes time to make parachute payments. As such, it would be prudent to structure the agreements in compliance with Section 409A.
Author: Nadia A. Havard
Originally published in October 2020
Copyright © 2020 Knox McLaughlin Gornall & Sennett, P.C.