Deferred compensation may be hidden in conventional contract provisions
Section 409A can apply to severance, equity and phantom-equity arrangements, expense reimbursements, and the timing of payments. The question is not simply whether an agreement has a heading called “deferred compensation.”
This overview is particularly relevant to executives and investment professionals with material deferred-compensation, severance, equity, phantom-equity, or other tax-sensitive payment arrangements.
Why it matters
A Section 409A failure can cause vested deferred compensation to become currently taxable even if the executive has not received cash or has no practical liquidity. The executive may owe regular income tax, an additional 20% federal tax, and penalty interest generally calculated from the year the compensation was first deferred or vested.
What we help you understand
- Which deferred-compensation arrangements and other promised payments or benefits may be affected by the federal tax rule
- When a payment can be made without changing the intended tax treatment
- Whether severance, equity and phantom-equity arrangements, or expense reimbursements need to be coordinated
When deferred-compensation rules apply
A timing mistake can trigger current tax and penalties even when the executive has not received cash. Many provisions that do not look like a deferred-compensation plan can be treated as deferred compensation for tax purposes. The employment agreement should be reviewed so that payment timing, separation provisions, reimbursement rights, equity features, and deferral arrangements work together and do not inadvertently create a Section 409A problem.
Severance and separation payments
Severance provisions require attention to eligibility, release conditions, payment timing, installment treatment, reimbursement provisions, and the definition of separation from service. These details can affect whether an intended payment structure is workable under the applicable tax rules.
Equity and phantom equity
Certain equity and phantom-equity arrangements require specialized analysis because their value, vesting, exercise, settlement, payment timing, and termination treatment may affect tax treatment. The label used for the award is not always determinative.
Reimbursements and other benefits
Expense reimbursement and benefit provisions can also create issues if the agreement gives the executive open-ended rights, changes the timing of reimbursement, or permits substitution for cash compensation. These provisions should be drafted as part of the overall compensation arrangement.
Frequently asked questions
Is Section 409A relevant only to deferred-compensation plans?
No. For Section 409A purposes, many forms of compensation can potentially be deferred compensation depending on their terms and payment timing. Examples can include annual bonuses, restricted stock units (RSUs), performance stock units (PSUs), phantom equity, change-in-control payments, severance, reimbursement rights, and other provisions commonly found in executive employment agreements.
Why is it important to address Section 409A at the outset?
Section 409A issues can become more difficult to correct once terms have been agreed or implemented, and available correction relief is limited and subject to conditions. A provision that seems commercially straightforward can create adverse tax consequences if its timing, conditions, or discretionary features do not comply with the applicable rules.
Early review helps structure the employment, incentive, equity, deferred-compensation, and severance provisions together before the executive agrees to terms that may produce current taxation, an additional 20% federal tax, interest, or other penalties.
What happens if Section 409A is violated?
A failure can cause vested deferred compensation to become currently taxable, even if the executive has not received cash or has no practical liquidity. The executive may owe regular income tax, an additional 20% federal tax, and penalty interest generally calculated from the year the compensation was first deferred or vested. In general, those federal tax consequences fall on the executive even if the underlying drafting or administrative failure originated with the employer. State tax consequences may also apply. For example, executives subject to California tax may face an additional 5% California tax in connection with certain Section 409A failures.
Why not simply add a standard Section 409A savings clause?
Section 409A savings clauses are common, but they are not a substitute for properly drafted payment terms. A general catch-all sentence may help address a genuine ambiguity, but it will not cure a significant Section 409A defect.
Can severance or reimbursement provisions create a Section 409A issue?
They can. The timing and conditions of severance payments and reimbursements can require careful analysis under Section 409A of the Internal Revenue Code. The operative payment terms, not merely a savings clause, should be drafted with that possibility in mind.
Do tax-exempt organizations have special deferred-compensation rules?
Yes. Deferred-compensation arrangements at tax-exempt organizations can be subject to Internal Revenue Code Section 457, including Section 457(f), as well as Section 409A. Under Section 457(f), an executive may be taxed when a substantial risk of forfeiture lapses, even if payment is scheduled for a later date. Careful drafting of vesting, forfeiture, payment, and separation terms can be important.