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He Fought the Law, and 409A Won

He Fought the Law, and 409A Won

March 14, 2013

Authored by: Chris Rylands

In this recently reported case, one Dr. Sutardja, a recipient of an allegedly discounted option, sued to recover 409A taxes imposed by the IRS.  The case does not decide whether the option was discounted, but Dr. Sutardja argued that his option, even if discounted, shouldn’t be subject to 409A.

Essentially, he tried to argue that (1) the grant of the discounted option is not a taxable event, (2) stock options aren’t “deferred compensation,” (3) he didn’t have a legally binding right until he exercised the option, or (4) 409A couldn’t apply to the discounted option.  Those familiar with 409A will sigh upon reading the list since clearly none of these arguments holds any water.  Discounted options are subject to 409A and must have fixed dates for exercise and payment.

The interesting part of the case, though, was the government arguing that Dr. Sutardja did not have a legally binding right to the supposedly discounted option until it vested.  This is an interesting argument for the government to make because the 409A regulations themselves say:

A service provider does not have a legally binding right to compensation to the extent that compensation may be reduced unilaterally or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed. … For this purpose, compensation is not considered subject to unilateral reduction or elimination merely because it may be reduced or eliminated by operation of the objective terms of the

Common 409A Misconceptions

Common 409A Misconceptions

July 24, 2012

Authored by: benefitsbclp

Every 409A attorney knows the look. It’s a look that is dripping with the 409A attorney’s constant companion – incredulity. “Surely,” the client says, “IRS doesn’t care about [insert one of the myriad 409A issues that the IRS actually, for some esoteric reason, cares about].” In many ways, the job of the 409A attorney is that of knowing confidant – “I know! Isn’t it crazy! I can’t fathom why the IRS cares. But they do.”

There are a lot of misconceptions out there about how this section of the tax code works and to whom it applies. While we cannot possibly address every misconception, below is a list of the more common ones we encounter.

I thought 409A only applied to public companies. While wrong, this one is probably the most difficult because it has a kernel of truth. All of the 409A rules apply to all companies, except one. 409A does require a 6-month delay for severance paid to public company executives. However, aside from this one rule, all of 409A’s other rules apply to every company.

But it doesn’t apply to partnerships or LLCs. Wrong, although again a kernel of truth. Every company, regardless of form, is subject to 409A. However, the IRS hasn’t yet released promised guidance regarding partnerships or LLCs, most of the 409A rules (like the option rules) apply by analogy.

But I can still change how something is paid on a change of control. Maybe, but maybe not. If a payment is

Facebook and 409A: When $300 Million Isn’t Enough

Facebook and 409A: When $300 Million Isn’t Enough

May 22, 2012

Authored by: benefitsbclp

On May 18th, two famous, photogenic Olympians found themselves almost $300 million richer. A banner day for anyone, and yet they may have felt at least a twinge of regret. Why? They contend that 409A should have made them much richer, to the tune of as much as $1.2 billion.

At this point, Hollywood has made the story almost old-hat. In December 2002, then Harvard students Tyler and Cameron Winklevoss had an idea. They would develop a web site that connected Harvard students. If successful, they would expand the concept to other campuses. In November of 2003, after several false starts, the Winklevoss twins retained the services of a young, talented programmer to implement their vision. Three months later, without the knowledge of the Winklevoss twins, Mark Zuckerberg gave birth to Facebook. After a successful run at Harvard, the social networking site spread to other campuses, and then took over the world.

In 2004, the Winklevoss twins (and their company ConnectU) filed suit against Facebook, claiming that Mark Zuckerberg had copied their social networking ideas and source code and used them to create Facebook. In 2008, the parties settled, reportedly for $65 million – $20 million in cash and a specified number of shares of Facebook. The problem was the valuation of Facebook stock at the time of the settlement.

Around the time of the settlement, Microsoft made an investment in Facebook. This investment valued Facebook at $15 billion. The Winklevoss twins apparently used this valuation, with a per share

Five Common 409A Design Errors: #5 Payment Periods Longer than 90 Days

This post is the fifth and final post in our benefitsbclp.com series on five common Code Section 409A design errors and corrections. Go here, here, here, and here to see the first four posts in that series.

Code Section 409A abhors discretion. One concern with discretion is that it could lead to the type of opportunistic employee action or employer/employee collusion that hurt creditors and employees during the Enron and WorldCom scandals.

Another concern is that discretion could be used opportunistically to affect the taxation of deferred compensation. Consider an employment agreement with a lump-sum payment due at any time within thirteen months following a change in control, as determined in the employer’s discretion. This provision would permit the employer to pick the calendar year of the payment. Because non-qualified payments are generally taxable to the recipient when paid, this type of provision would allow a company to essentially pick the year in which the employee is taxed on the payment. In this situation, the IRS would be concerned that the plan participant (who often has great influence with the company) would collude with the company so that the resulting payment was of most tax benefit to the participant.

Code Section 409A addresses this problem by restricting the timing of a deferred compensation payments following a triggering event to a single taxable year, a period that begins and ends in the same taxable year, or a period of up to 90

Five Common 409A Design Errors: #4 No Six-Month Delay for Public Company Terminations

This post is the fourth in our benefitsbclp.com series on five common Code Section 409A design errors and corrections. Go here, here and here to see the first three posts in that series.

Code Section 409A is, in part, a response to perceived deferred compensation abuses at companies like Enron and WorldCom. The story of Code Section 409A’s six month delay provision is inextricably tied to the Enron and WorldCom bankruptcies.

Under established IRS tax principles, participants’ rights under a non-qualified plan can be no greater than the claims of a general creditor. Because deferred compensation plans often pay out upon termination of employment, a plan participant with knowledge of a likely future bankruptcy could potentially terminate employment and take a non-qualified plan distribution to the detriment of the company’s creditors (a number or Enron executives with advance knowledge of Enron’s accounting irregularities did just this). This opportunistic cash out is obviously unfair to the company’s creditors. In addition, the cash out only helps hasten the likely bankruptcy because non-qualified plan payments come from the general assets of the company.

How did Congress solve this problem? By requiring that a payment of deferred compensation to any of the most highly compensated employees of public companies (called “specified employees”) be delayed at least six months if the payment is due to a separation from service. The thought was that for public companies (like Enron and WorldCom), plan participants would not have enough time to

March 15th: Code Section 409A Day

March 15th: Code Section 409A Day

March 12, 2012

Authored by: benefitsbclp

Your company sponsors an annual bonus program. Bonuses are tied to company calendar year performance. The bonus plan says that payments are to occur by March 15th of the year following the performance year. March 15th has always struck you as an odd date.

A friend at another company calls you up, very excited. Her company’s financial performance last year was stellar, and she’s expecting a large payment by March 15th. Another friend at a different company mentions that he’s buying new furniture on the 17th. The proximate cause? Annual bonuses are paid on March 15th.

It is no coincidence that companies often pay out annual bonuses around March 15th. In the case of a company with a calendar year tax year, paying bonuses by March 15 will generally allow the company to deduct the bonuses in the tax year which ends on the prior December 31. But there may be another reason for structuring bonus payouts in this manner: to comply with Code Section 409A.

Code Section 409A generally applies when the right to an amount arises in one year, but the amount can be paid in the next. So, for example, an annual bonus paid shortly after the end of a calendar year could potentially be subject to Code Section 409A.

However, amounts paid by the 15th day of the third month following the end of the year in which the amount “vests” are exempt from Code Section 409A as “short term deferrals.” Thus, March 15th.

But what

Five Common 409A Design Errors: #3 Multiple Forms of Payment

Five Common 409A Design Errors: #3 Multiple Forms of Payment

March 8, 2012

Authored by: benefitsbclp

This post is the third in our benefitsbclp.com series on five common Code Section 409A design errors and corrections. Go here and here to see the first two posts in that series.

Let’s say that you are negotiating your CEO’s new employment agreement. Because she is preparing for retirement, the CEO would like to be entitled to a stream of monthly lifetime separation payments upon her voluntary termination. This type of lifetime benefit makes sense for your company, and, based on the CEO’s long and faithful service to the company, you agree.

The CEO then asks for a provision calling for an immediate lump-sum payment upon her involuntary termination. The amount of the payment would be the present value, using reasonable actuarial assumptions, of the monthly separation pay annuity. This request seems reasonable – the fact that things may go sour in the future doesn’t change the fact of the CEO’s long service. And in an involuntary termination situation, who would want to receive payments over a period of time rather than in a lump sum? Should you agree to this request?

No. And regular readers of this blog will not be surprised as to why – Code Section 409A.

Code Section 409A generally requires that payments be made in a single form following each permissible payment triggering event. This means, for example, that a plan couldn’t provide for payment of an amount in a lump-sum if a change in control occurs in a January

Five Common 409A Design Errors: #2 Reimbursements

Five Common 409A Design Errors: #2 Reimbursements

February 24, 2012

Authored by: benefitsbclp

Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections.

It should (but will not) go without saying that Code Section 409A has an extraordinarily broad reach. Many claim this reach is overbroad. One commonly cited example of this overbreadth is that Code Section 409A regulates taxable employee reimbursements.

Why does Code Section 409A regulate reimbursements? The concern is that an employee and employer will collude to achieve reimbursement of extravagant personal expenses many years after the expense is incurred. This “late” reimbursement would have the effect of unreasonably deferring taxation of the reimbursable expense, potentially into a year that is tax-advantageous for the employee.

The IRS’s solution? Ensure that expenses eligible for reimbursement are objectively determinable and reimbursed within a limited period of time following the date in which the expense is incurred. Here’s a list of the IRS’s requirements:

  • Definition of Reimbursable Expense. Code Section 409A requires an objectively determinable definition of an expense eligible for reimbursement. The description of the reimbursable expense does not need to be extensive, but does need to be written into the relevant plan document (which could be an employment agreement).
  • Prescribed Reimbursement Period. Eligible expenses must be incurred during a prescribed period of time. This period of time can be as long or as short as desired – the lifetime of the service provider works for Code Section 409A purposes. Again, this needs to be written into the plan document.
  • Reimbursement

Five Common 409A Design Errors: #1 Employment Claims Releases

Five Common 409A Design Errors: #1 Employment Claims Releases

February 15, 2012

Authored by: benefitsbclp

Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections.  This is the first of those posts.

You are designing an executive employment agreement with a substantial severance component. For the amount of severance, it seems fair to condition payment upon execution of an agreement waiving all employment claims (ADA, age discrimination, etc.). Why not just say that severance payments don’t begin until the executive returns the claims release? The answer – Code Section 409A.

Incredulous? Here’s the concern. An employee who will begin to receive severance upon return of a release could potentially hold on to the release until the year following his or her termination. What does that achieve? Because the severance is taxable when actually paid, the employee could hold on to a release, defer taxation, and ultimately pay fewer taxes on the severance. Employee discretion as to the timing of taxation exercised opportunistically upon termination of employment is anathema to Code Section 409A.

There are two common solutions to this design problem, both with advantages and disadvantages.

‘Tis the Season to Double-Check for 409A Compliance

‘Tis the Season to Double-Check for 409A Compliance

December 13, 2011

Authored by: benefitsbclp

‘TIS THE SEASON to check executive deferred compensation practices for operational compliance with section 409A of the Internal Revenue Code and the specific terms of company plans and employment agreements.

Common operational errors include deferring too much or too little and making distributions too large, too small, too early or too late.

Even a minor operational error can cause trouble unless it is corrected promptly. Some types of operational errors discovered in the year of the error or one of the next two years can be corrected without ruinous results under IRS procedures. This makes it appropriate to review your 2011 deferral and distribution records to make sure everything is just right or to identify issues and make prompt corrections. If you did not review your records for 2009 or 2010, that also would be worth doing now. Although the corrections approved by the IRS are more difficult and more costly for errors that occurred in the two prior years, making an approved correction is still far better than the onerous taxes imposed on the affected employee if no correction is made.

The correction procedures are described at length in IRS Notice 2008-113. Please call us if we can be of assistance.

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