April 29, 2011 (PLANSPONSOR.com) – In the April 2011 edition of the Trucker Huss Benefits Report, attorneys from the firm list some common Internal Revenue Code Section 409A errors.
Addressing substitution payments, Mary E. Powell and J. Marc Fosse noted that when an executive is terminated, a company may seek to negotiate severance payments that are structured differently than the severance payments in the executive’s employment agreement. If severance payments are subject to Section 409A, then generally the time and form of payment cannot be changed merely by forfeiting or relinquishing rights under an old agreement for payments under a new agreement. This is considered a substitution payment under Section 409A and a substitution payment must retain the same time and form of payment as contained in the original agreement, the newsletter said.
Next the attorneys noted that a termination of employment occurs under Section 409A when the employer and employee reasonably anticipate that no further service will be performed for the company (or its parent or subsidiaries) after a certain date, or that the level of bona fide services to be performed after that date (either as an employee or independent contractor) will decrease to 20% or less of the bona fide services performed by the employee on average over the prior 36-month period. Under Section 409A, services as a consultant count when determining whether there has been a termination of employment, so if the company retains the executive to provide consulting services at a rate of 50% of the services she provided as an employee, then she is deemed to have not terminated employment with the company for purposes of Section 409A, and any payments under a nonqualified deferred compensation plan that were to commence at termination of employment cannot begin until the executive has a true termination of employment.
According to the report, in general, if an agreement states that payment will be made immediately upon vesting of an award—that award is exempt from Section 409A under the short-term deferral rule. However, some long-term bonus plans and restricted stock unit plans contain early vesting provisions for “retirement” which state that if the employee meets certain age and service requirements, then the employee can terminate at any time and receive either a prorated or full bonus or award. Because this bonus or award is “vested” once the employee satisfies the age and service criteria, but payment may be made in a subsequent tax year after vesting, these awards or bonuses are not short-term deferrals and are not exempt from Section 409A.
Section 409A generally provides that compensation for services performed during a taxable year may be deferred at the employee’s election if the election to defer such compensation is made not later than the close of the taxable year preceding the year in which the services are rendered. However, sometimes employers mistakenly allow employees to defer a discretionary bonus into a deferred compensation plan in the year before it is paid — rather than the year before it was earned. The newsletter provided an example of an employer announcing in 2010 that it will be awarding discretionary bonuses for services performed in 2011, and will decide which employees will receive bonuses and in what amounts at the beginning of 2012. The attorneys point out that the election to defer the discretionary bonus must occur no later than December 31, 2010 (the taxable year immediately preceding the year before it is earned) — not December 31, 2011 (the taxable year immediately preceding the year before it is paid). This rule leads to the fifth common 409A error listed in the newsletter. When past services are used to calculate the benefits and the employee is immediately vested in the plan benefit as of the day he becomes a participant in the plan, then it could be a violation of Section 409A for the employee to make an election as to the time and form of payment under the plan because the election would apply to services already performed. Instead, the plan must specify the time and form of payment. One exception permits an employee to make elections regarding the time and form of payment for a benefit that includes past services if the elections are made within the first 30 days of the date the employee becomes a participant and the benefit will not vest for at least 12 months after the 30-day election period.