409A Impact on Employment Agreement Compensation

February 14th, 2008

There has been a lot of information released recently about the impact of Section 409A on traditional nonqualified deferred compensation plans.  However, what most employers don’t realize is that the 409A rules can also impact some of the common provisions relating to compensation arrangements contained within individual employment agreements.  Because Section 409A defines deferred compensation extremely broadly, some types of compensation that an employer might view as current may actually fall within the expansive scope of Section 409A.

A non-discretionary bonus which is paid in the year following the year in which it is earned may be encompassed within the 409A definition of deferred compensation.  However, a short-term deferral exception exists which removes these types of bonuses from the deferred compensation arena.  Generally, this exception provides that if the bonus is payable no later than March 15th of the year following the year in which services were performed then the bonus program is exempt from Section 409A.  However, if the bonus is paid by the employer after March 15th, the exception will no longer apply and 409A rules come into play.

Individual employment agreements may contain a provision that allows the employee to receive compensation in the event of a change in control.  While these types of payments are allowed by Section 409A, the change in control event defined in the employment agreement must match the definition for a change in control as given in the regulations.

Severance plans are usually considered deferred compensation, and are subject to Section 409A compliance unless a specific exception exists.  Under Section 409A, severance payments include cash, continuation of benefits, tax gross-ups, and any other kind of post-employment benefit or payment.  Most existing severance agreements will probably either already comply with 409A requirements or fall within an allowable exception.  However, frequently severance agreements are negotiated at the time of separation.  The problem then becomes that Section 409A does not allow for the restructure or renegotiation of severance agreements at the time of termination if the severance agreement is to fall within the 409A rules.  Additionally, with regard to severance plans, voluntary termination and involuntary termination are looked at and treated differently under 409A.

Taxable post-termination reimbursements and in-kind benefits are considered by the IRS to be deferred compensation, and, as such, would be subject to 409A regulation.  If an employer has employment agreements with individuals that contain provisions for post-termination reimbursements and/or in-king benefits, these types of arrangements can be restructured to comply with the final regulations.

The application of 409A rules to employment agreements means that employers will have to change their procedures for negotiating and implementing employment agreements.  The new rules require more specificity in employment agreements, the use of a greater level of pre-established rules and procedures in the agreements, and a decreased ability to make subsequent changes to the agreement provisions.  Employers would be well-served to engage benefits counsel to assist them in identifying, analyzing, and amending all written and unwritten employment agreements that might contain any deferred compensation provisions under 409A.

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