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Hidden Deferred Compensation Arrangements

Hidden Deferred Compensation Arrangements

Originally published in October 2020

Section 409A on Deferred Compensation Arrangements

Deferred Compensation in Light of Section 409A

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:

attract the top talent in our leadership positions and motivate our executives to deliver the highest level of individual and team impact and results;
encourage our executives to model the important aspects of our culture, which include moving fast, being bold, communicating openly and building trust with each other and our employees;
ensure each one of our named executive officers receives a total compensation package that encourages his or her long-term retention;
reward high levels of performance with commensurate levels of compensation; and
align the interests of our executives with those of our stockholders in the overall success of Facebook by emphasizing long-term incentives.

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:

base salary;
performance-based cash incentives; and
equity-based compensation in the form of RSUs or other share-based compensation

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] […]”

General Compliance with Section 409A

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.)

No Deferred Compensation, Exemptions and Exceptions

No Deferred Compensation

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:

The employment agreement provides that “the employer retains its right, which is exercisable in the employer’s sole and absolute discretion, to eliminate any severance payments granted to the employee under this agreement at any time prior to the employee’s termination of the employment”. Since the employer could have eliminated the promise to pay upon termination at any time prior to the employee’s termination in the employer’s sole and absolute discretion without the employee’s consent or any other input, the employee does not have any legally binding right to this payment. The right springs to life upon the employee being actually terminated.
Another example relates to situations when the employment agreement was silent regarding any severance pay. At the time of termination, the employee and the employer actually negotiate the severance pay. The agreement will provide for a lump-sum payment of severance. If the time and form of payment are agreed upon before the agreement is signed, the rights to severance pay under this agreement are not deferred compensation. This example is different from a situation when the employee already has an agreement calling for severance payments upon his termination. The employee cannot renegotiate the timing of severance payments after he has been fired, without, potentially, subjecting the payment to Section 409A requirements. The executive’s right to severance pay became legally binding upon his termination.

Short Term Deferral

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:

An employment agreement provides that “a bonus will be paid as soon as practical after the end of the calendar year performance period”. If the agreement does not specify that such bonus must be paid within 2 ½ months after the right to bonus is earned and vested, the agreement, as drafted, clearly deals with the deferred compensation (ie. bonus payment that is earned and vested in one year will be paid sometime in the next year). Since the right to bonus was earned and vested as of the end of the calendar year, the bonus amount should be reported as income for that year. On the other hand, if the employment agreement would have clearly stated that the bonus must be paid within 2 ½ months from the end of the calendar year, then bonus would have been exempt from being deferred compensation. As such, it will be included in the calendar year it is paid (provided, that indeed it is paid by the end of the calendar year following the performance year).
Another example deals with the severance pay. Let’s say that the agreement provides that the employee will be paid severance upon termination, provided the employee executes a release of claims. Without any other requirement that will lock the execution of the release to a particular deadline and conditions execution upon forfeiture of the right to pay, as drafted, the severance pay will be outside Section 409A exception. It will have to meet deferred compensation requirements. In order to exempt it from being a deferred compensation, the agreement must clarify the deadline when the release should be signed (thus giving legally binding right to pay without substantial risk of forfeiture) and the severance pay must be made in lump-sum within 2 ½ months after this right is vested or pursuant to the fixed pay schedule.
What about if the agreement provides that “payments will be made for twelve months upon the employee’s termination”? Again, as a reminder, the short-term deferral exempts payments from being deferred compensation if such payments are made within 2 ½ months after the end of the year when the right to the payment is earned and vested. In this example, the agreement is not specific enough to fall within short term exemption. Even though it is a possibility that the employee is terminated prior to March 15 so that payments referred to in the agreement indeed are made by March 15 of the following year, there is also an equal possibility that such termination will occur after March 15 and severance pay will be paid more than 2 ½ months after the year of termination. Since the payments are not exempt from being deferred compensation, the agreement must contain additional provisions that either follow 409A requirements in general or specifically mirror the separation pay exemption. If the agreement has none of these but only the language listed above, the employee must include the promised payments in his/her income in the year when the agreement is signed (since upon signing the agreement the employee has a legally binding right to these deferred payments).
Another example illustrates the need for understanding the terms of the agreement. Are they sufficient to exempt the pay from being deferred compensation or insufficient to qualify for exemption? If they fail to exempt the pay from being deferred compensation, do these terms comply with Section 409A? Consider this: the employment agreement provides that the executive is entitled to severance pay if he/she resigns within one year following a change of control in the company. Bear in mind, the so-called condition to receive pay lies solely within the executive’s sole discretion (i.e. voluntary decision to resign). As drafted, the agreement does not create substantial risk of forfeiture of the right to get severance pay. Since the agreement fails to create a substantial risk of forfeiture of the right to severance pay, the right got vested on the day the company’s control changed. The agreement does not require the severance pay to be paid within 2 ½ months after the year the executive’s right got vested. On the contrary, if the change of control in the company occurred on July 1, 2020 and the executive decides to resign on May 1, 2021, this severance pay will be made after May 1, 2021 (i.e. more than 2 ½ months after year 2020). So, what is the practical implication of this? Since the agreement fails to exempt the executive’s pay from being deferred compensation, the agreement must contain additional provisions related to Section 409A or severance pay exception. If the agreement lacks such provisions, then the executive must include the promised severance pay in his/her income for 2020 (the year his right to pay got vested).
Another example: The bonus is based on employee’s performance in 2020 and is scheduled to be paid by March 1, 2021. The agreement provides that the bonus will be lost unless the employee is still employed through the March 1 payment date. Since the bonus is subject to a risk of forfeiture until the date it is actually paid, it will qualify as the short-term deferral exception. Furthermore, if this agreement is reduced to a writing and, due to financial difficulties the company (i.e. an unforeseeable event) did not make a payment on March 1, the payment still can be made by December 31, 2021 and still comply with short term deferral exception.

Severance/Separation Pay

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:

The pay must be paid by the end of the 2^nd year following the year of termination.
The pay does not exceed twice amount of either the base salary of the terminated employee from the prior year or the IRS imposed limit on compensation for qualified retirement plans, whichever is lesser.
The window program must not last more than 12 months and must specify circumstances allowing employees to resign.
“Good reason” definition found in the agreement must either have 409A general definition (i.e. “material negative change” in the employment relationship requiring the employee give notice and allowing for cure period) or spell out 409A good reason safe harbor.
The “good reason” safe harbor presupposes a period of up to 2 years after one of the enumerated conditions arises without employee’s consent (such as a material diminution in base salary, authority, duties, or budget under the employee’s oversight, or change of the geographic location of work, and any other material breach of the employment agreement). The amount, time and form of payment must be substantially identical to payments under involuntary termination. Additionally, the employee must give a 90-day notice from the date the condition arises and the employer must have 30-day cure period to fix the problem.
If the agreement does not follow “good reason” definition of Section 409A or fails to list conditions and other requirements under “good reason” safe harbor, but does provide for severance pay for good reason, the severance pay is deferred compensation. Again, it is not the end of the world if the agreement follows general requirements of Section 409A related to fixed pay schedule, etc. If, however, the agreement does not follow 409A section requirements and has noncompliant “good reason” provisions, the executive must include compensation in the year the agreement is signed. Here is an example: The agreement states that “upon executive’s termination, the executive will be paid two times base salary”. The agreement, as drafted, (i) does not condition the termination pay upon involuntary termination, (ii) nor does it require termination for “good reason”. As such, even though the executive can be terminated involuntarily, the promised severance pay is deferred compensation. Unless the agreement also includes Section 409A general provisions re the pay, it must be included in the executive’s income in the year the agreement is signed.
Here is another example: The agreement provides that the employee will receive $200,000 within 60 days of voluntarily terminating the employment for good reason. The agreement further defines the term “good reason” as “the material reduction in base pay of the executive.” The agreement, however, does not contain a notice and cure period within its definition of “good reason”. As a result, the agreement (and the payments thereunder) fail to meet the requirements of the short-term deferral or separation pay plan exemptions. Since the agreement has a noncompliant definition of good reason, it is outside Section 409A exemptions.

Expense Reimbursement and Other Indemnification Agreements

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.

For example, consider an employment agreement that caps reimbursable expense over three years (the entire duration of the agreement) to $30,000. The agreement does not require the employee to be employed during the tax year the expense occurred (for example, a retired employee). It also fails to require the employee to submit request for reimbursement within 2 ½ months after the tax year the expenses have been incurred. So, this reimbursement provision does not qualify under short-term deferral and must comply with Section 409A. One of the requirements imposed by Section 409A is that the reimbursement in one taxable year must not affect amounts to be reimbursed in the subsequent tax year. The provision mentioned above, as drafted, violates Section 409A since the amount of expenses eligible for reimbursement in tax year 1 will likely affect the amount eligible for reimbursement in tax year 2. If the employee incurs $10,000 of expenses in tax year 1, the amount eligible for reimbursement in year tax 2 is necessarily reduced. In order to correct the error, the agreement must require to pro-rate the capped amount among the tax years in which the reimbursement could occur. (e.g. $10,000 in each year). The simple solution is to set annual cap on reimbursement amounts.
Another example: The employment contract provides that the company will reimburse the employee for moving expenses, such as relocation costs and airfare. The agreement is silent as to when the reimbursement must be paid. As drafted, the reimbursement clause fails to exempt the pay as short-term deferral. It also fails to comply with Section 409A. As a result, even though the expenses could have been deducted by the employee if the employee claimed these expenses on Form 1040, tax and penalties will be imposed on the amounts reimbursed. The solution is to require the employee to submit receipts for reimbursement within 2 ½ months of the tax year end when the expenses occurred.

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:

Tax indemnification;
Gross-up agreements;
Indemnification for the legal expenses of former employees;
Relocation make-whole agreements

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.

Modification or Renegotiation of Existing Agreements

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.

Other Arrangements That Require Closer Look

Equity Based Compensation
Performance Pay
Parachute Payments Contingent on a Change of Ownership or Control of Employer

Equity Based Compensation

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:

Top-hat plans
Supplemental Executive Retirement Plan (SERP)
Shadow and Tandem 401(k) plan
Unfunded rabbi trusts as a funding vehicle for the employer
Equity-Based Compensation (e.g. stock appreciation rights, stock options, restricted stock units)

Stock option agreements will be outside Section 409A per Treas. REg. 1.409A-1(b)((5)(i)(A) if:

The stock option is issued on the stock of the company that receives the services, including a parent company’s stock, if the parent owns at least 50% of the subsidiary;
The exercise price may not be less than the fair market value of the underlying stock on the date the stock option is granted (e.g. the FMV of nonpublic stock must be determined by a reasonable method, taking into account all relevant facts and circumstances, the value of tangible and intangible assets, present value of the anticipated cash flow, any resent arm’s-length sales or transfers);
The number of shares subject to the stock option is fixed on the date the option is granted;
The option must not have any additional rights that will allow to further defer income inclusion beyond the date it would have been included; and
The amount payable upon exercise or disposition of the stock option cannot be deferred beyond such exercise or disposition.

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:

The stock appreciation rights are issued on the stock of the company that receives the services, including a parent company’s stock, if the parent owns at least 50% of the subsidiary;
The exercise price equal to appreciation over the fair market value of the underlying stock on the date the stock appreciation rights are granted;
The number of shares subject to the stock appreciation rights is fixed on the date the stock appreciation rights are granted;
The stock appreciation rights must not have any additional rights that will allow to further defer income inclusion beyond the date it would have been included; and
The amount payable upon exercise of the stock appreciation rights cannot be deferred beyond such exercise or disposition. The amount payable upon exercise of the stock appreciation rights is locked to the difference between the FMV at the time the rights are settled over the FMV at the date they were granted.

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:

delivering equity values that are highly competitive when compared against those our peers would grant to executives with similar responsibility;
each executive officer’s individual performance assessment, the results and contributions delivered during the year, as well as the anticipated potential future impact of each individual executive;
the size and vesting schedule of existing equity grants in order to maximize the long-term retentive power of all additional grants; and
the size of each executive officer’s total cash compensation (base salary plus cash bonus awards at target), which is generally lower than the cash compensation for executives with similar responsibilities at our peer companies.

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."

Performance Pay

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.

Parachute Payments Contingent On a Change of Ownership or Control of Employer

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:

Purchase of 50% of the company stock based either on value or voting rights;
Purchase within one year of company stock having 30% of voting power;
Change in a majority of board of directors members over a period of one year;
Transfer of at least 40% of gross value of assets to a third unrelated party.

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