Law Firm Discusses Common 409A Errors

April 29, 2011 ( – 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.

In the April 2011 edition of the Trucker Huss Benefits Report, attorneys Mary E. Powell and J. Marc Fosse note that under Section 409A, death is a permissible payment date. However, some deferred compensation plans state that payment will be made within a specified pe­riod after the plan receives notice or evidence of the death. Notice or evidence of death is not a permissible payment event under Section 409A. Accordingly, a pro­vision that states, “the Company shall pay to the par­ticipant’s beneficiary a death benefit equal to the amount of the participant’s account in a single lump sum following receipt of notice of the participant’s death” would not comply with Section 409A.  

The newsletter said the ability to offset payments from a nonqualified de­ferred compensation plan based on other benefits or debts owed to the company is highly restricted under Section 409A. Common errors include offsetting the amount of one deferred compensation plan from an­other deferred compensation plan. This type of offset can work if designed so that payments under both de­ferred compensation plans commence at the same time and are paid in the same form — which is not usu­ally the case.  

If a deferred compensation plan payment is contingent on the execution and irrevocability of a general release, the plan must state that the benefit will be payable ei­ther (a) on a specific date — such as on the 60th day after separation from service or (b) during a designated period not longer than 90 days after separation from service, but if the designated period begins in one tax­able year and ends in a second taxable year, then the payment must be made in the second taxable year. As an example the attorneys note that if benefits under a separation agreement are subject to Section 409A and the agreement states sim­ply that the payment will be made within 60 days of separation of service, contingent on the execution of a general release, then the agreement likely fails to com­ply with Section 409A.  

Severance plans drafted to be exempt from Section 409A generally rely on either the short-term deferral ex­emption or the separation pay plan exemption, or both. To meet these exemptions, these severance plans are drafted so that payment is dependent on the employ­ee’s involuntary termination of employment. The sever­ance plan may also permit payment upon the employ­ee’s voluntary termination for “good reason.” However, sometimes this definition of “good reason” fails to meet the requirements of Section 409A (a bad “good reason” definition) and inadvertently the company fails the ap­plicable Section 409A exemptions. The Section 409A regulations have a safe harbor definition for good reason, and the attorneys suggest sponsors use this safe harbor definition.  

Finally, the attorneys said that sometimes the plan document definition of compensation for elective deferrals under a plan and the actual operation of the plan do not match causing a Section 409A operational violation. For ex­ample, the deferred compensation plan may state that the amount deferred is calculated based on compensa­tion paid before any deferrals to the company’s 401(k) plan, but when the company’s payroll de­partment implements the deferral election, it calculates the deferrals based on compensation paid after the ap­plicable 401(k) deferrals. This creates an operational violation under Section 409A because too little has been deferred to the deferred compensation plan.  

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