Last week, we looked at employment agreements and planning for issues in executive employment agreements. One interesting aspect of employment agreements is that they can generate many different legal issues. Stripped down, an employment agreement is a contract. In addition to fundamental contract law, however, the language within an employment contract can, directly or indirectly, give rise to other issues including wage laws, taxation, discrimination, corporate law, confidentiality, non-competition, and employee benefits. The arena of employee benefits itself is diverse and complicated. Signing bonuses, severance pay, change of control agreements, incentive pay, and participation in the employer’s basic benefit plans are just some examples of the employee benefit aspects that are often found within an employment agreement. Today we will focus on the inclusion of a specific form of employee benefits within an employment agreement, deferred compensation.
Deferred compensation can exist in many forms, and the rules and exceptions that apply to deferred compensation are far too numerous and complex to attempt to fully describe here. What we can do, however, is:
- identify what deferred compensation is, at its most fundamental level;
- describe some of the most common forms of deferred compensation found in employment agreements;
- discuss why it is important to pay close attention to the rules and regulations surrounding deferred compensation; and
- identify some of the most common mistakes and problems that arise due to the inclusion of deferred compensation in an employment agreement.
Remember, the rules, definitions, and other items discussed here are general and summary in nature. If you are preparing, amending or reviewing an employment agreement that you believe may or should include elements of deferred compensation, you are strongly encouraged to consult with an experienced employee benefits lawyer.
Why Should I Care?
The rules regarding deferred compensation are contained in Section 409A of the Internal Revenue Code and the related regulations. Before we move on to talk about what deferred compensation is, let’s understand why we should even care. Section 409A regulates the payment of deferred compensation arrangements. The details of 409A are vast and complex, but for now let’s just recognize the penalties that result if the rules of 409A are not followed. First, all amounts payable under the deferred compensation arrangement become immediately included in the taxable income of the employee in the year in which such amounts are no longer subject to a “substantial risk of forfeiture.” This is true whether the amounts have actually been paid to the employee or not. So, what is “substantial risk of forfeiture?” Honestly, I could write an entire series of blogs just on that topic alone. Many applications of the rules under 409A hinge upon the creation and continued existence of risk of forfeiture. For now, let’s just agree that it means “the requirement of the employee to continue performing services for the employer.” In addition to the immediate inclusion in income, the employee will face a 20% excise tax on all amounts under the deferred compensation arrangement, as well as applicable interest penalties. These are formidable penalties which any employer and employee will certainly wish to avoid.
What is Deferred Compensation?
So, what exactly is deferred compensation? Simply put, it is any promise made by an employer to pay an amount to an employee in a subsequent year. I should point out that the actual definition does not use the terms “promise,” “employer” or “employee,” but we will use them here for simplicity. If you think about it, that is a very broad definition. Nearly ever aspect of an employee’s compensation and benefits would seem to meet that definition. An employee’s salary is a promise to pay that could result in payments made year after year. What about the amounts that an employer contributes each year to an employee’s 401(k) plan that will not be paid out for many years to come; is that deferred compensation? What about the typical severance language found in an employment agreement? We could go on and on. The truth is that all of these ARE examples of deferred compensation, at least initially.
Exemptions to the Rules
This conclusion may seem a little overwhelming. Fortunately, many of the typical aspects of compensation fall within designated exceptions to the deferred compensation rules. Among the exceptions are ordinary payroll, benefits paid under qualified retirement plans, the short-term deferral exception, most welfare and fringe benefit plans, separation pay plans, and many stock plans. A word of caution here: the short-term deferral exception and separation pay plans are not what you might think they are, and in any event are quite complicated. It is safe to say that designing and operating an arrangement to fit within an exception to the 409A rules requires a great deal of experience and planning
Typically, the types of deferred compensation found in an employment agreement that are subject to 409A include:
- signing bonuses paid over more than one year
- severance payments
- change of control benefits
- bonus arrangements, whether incentive based or not
- non-qualified plans that allow an employee to defer part of their salary
- certain equity-based arrangements
- retention, or “golden handcuff,” plans
In reality, there are many forms and variations of deferred compensation plans. Sometimes the language in an employment agreement that creates deferred compensation is very long and detailed and easy to spot; other times it might be just a few words innocently tucked in some obscure paragraph. Also, sometimes the deferred compensation plan or arrangement does not actually exist within the employment agreement itself but is instead found in a separate plan document that is incorporated only by reference in the employment agreement. Even more problematic is when the language in an employment agreement creates deferred compensation in some form when neither party intended to do so. Often the most important step in dealing with deferred compensation is recognizing its existence in the first place.
Complying with 409A
Once you recognize that your employment agreement will include deferred compensation, what’s next? Well, if the deferred compensation fits within an exception to 409A, then you are generally free from the concern of complying with the regulations. Alternatively, if your deferred compensation arrangement does not fit within an exception, the design and operation must comply with all of the requirements of 409A. It is very important to note that employment agreements are often amended or rewritten over time. Be careful that future changes do not alter either the original exempt status of the deferred compensation or cause an arrangement that is subject to 409A to fall out of compliance in some way. There are many limitations regarding the ability to make changes to an existing 409A covered arrangement. We will discuss some of those next.
Often a client will ask whether it is better to design deferred compensation to fit within a 409A exception, or to just draft the language so that the arrangement complies with 409A. The answer to that will largely depend on the desired benefits to be provided. Some forms of benefits are tailor-made for the exceptions to 409A, others are nearly impossible to make exempt. It is usually not difficult to design a deferred compensation arrangement so that it initially complies with 409A. The bigger problem with a 409A plan is the long-term operation of the plan. People like to change their minds when it comes to money, and 409A resists changes!
Changing the Agreement
Two of the fundamental concepts under 409A are:
- you cannot speed up the time or form of the payment of your deferred compensation
- you cannot slow down, or delay, the time or form of the payment of your deferred compensation.
There are certain tailored exceptions to these basic rules, but often the rules regarding the exceptions simply will not apply or are in some manner wholly impractical. For example, an employee is due to receive a lump sum bonus payment after five years of service. In year three, the employee wishes to delay the payment for two years and receive it in three equal annual installment payments.
This is typical of the type of change that clients request. In this example, it would not be possible to make the desired change. The rules regarding the change in time and form of payment are rigid and would not allow this modification. If you made this change without knowing this, the employee could become subject to the income inclusion, excise tax, and interest penalties described above.
There are other noteworthy potential changes to consider as well. What if the employer experiences a change in its ownership? What if the employer wishes to terminate the deferred compensation portion of the employment agreement? What if the parties wish to combine the existing deferred compensation arrangement with a new and different arrangement, or replace the existing arrangement with a new arrangement? These are important questions that do not usually have simple answers. There are, of course, many more potential deferred compensation speedbumps, touching on virtually every aspect of the creation, operation, modification, and ultimate payout of deferred compensation arrangements.
It is difficult to overstate the complexity of the 409A rules and the nearly infinite possibilities that can arise in designing and implementing an employment agreement that includes some form of deferred compensation. So, what should you do?
- First, spend some time thinking about what you wish to accomplish with your deferred compensation arrangement.
- Second, make sure your arrangement is designed in a manner that best fits your needs while complying in one manner or another with the 409A rules.
- Third, do not assume that you can make changes to your arrangement, no matter how subtle they appear, and make sure that any changes you do make will not violate the 409A rules.
Most importantly, recognize that your employment agreement does or may contain elements of deferred compensation, and seek the advice of an experienced employee benefits lawyer.
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