Executive Compensation

With apologies to those who want to focus solely on proxy season, this is my fourth Blog on significant new issues raised by IRS issued Notice 2010-6, Relief and Guidance on Corrections of Certain Failures of a Nonqualified Deferred Compensation Plan to Comply with § 409A(a) (the "Notice").  The Notice contains examples of situations that the 409A final regulations do not clearly address – and provides for significant penalties for many plan provisions that a normal person might view as a foot fault.

For example, to comply with 409A, a plan or agreement must provide for payment only upon a "permitted event," such as death, disability or a separation from service, and also must specify that the date of the event is the payment date, or specify another payment date (or a fixed schedule) that is objectively determinable and nondiscretionary.  A plan also may provide that a payment (including a payment that is part of a schedule), is to be made during a designated period objectively determinable and nondiscretionary at the time the payment event occurs, but only if the designated period (i) both begins and ends within one taxable year of the employee, or (ii) is not more than 90 days and the employee does not have a right to designate the taxable year of the payment.  Because of the difficulty of making payments exactly on the date of a permitted event, must plans and agreements require payment during a designated period after the permitted event.

So, what if an employer's plan or agreement does not precisely specify the designated period according to these foregoing requirements?

The good news is that the Notice permits the employer to amend the plan or agreement to precisely specify the designated period according to the requirements of the regulations.  The bad news is that the employer had better amend the plan or agreement quickly, or its affected employees could face stiff penalties.

For example, suppose Employee A has an employment agreement with Employer, which entitles Employee A to $100x severance upon a separation from service, payable within 180 days following the separation from service, with the exact timing of the payout within the 180 days in the Employer's discretion. 

• On February 1, 2011, Employee A has a separation from service. 
• On March 1, 2011, Employer pays Employee A the $100x severance, giving A no election regarding the timing of the payment
• On March 15, 2011, Employer amends the employment agreement to provide for payment within 90 days of Employee A's separation from service, with the exact timing of the payment within the 90 days at the Employer's discretion.

Despite the fact that Employer paid Employee the $100x severance well within 90 days following Employee's separation from service, Employer gave Employee no election regarding the timing of the payment, and Employer amended the employment agreement to comply with the 90-day rule within a short period of time following Employee's separation, the Notice provides that Employee A must include 50% of the amount deferred under the plan to which the pre-correction plan provision applied as an amount includible in income under 409A and pay all applicable Federal taxes, including the additional 20% tax on such amount (but not the additional premium interest tax), and Employer must report the amount in Employee's income under 409A for 2011 on the Form W-2, Box 1 and Box 12 using Code Z. The Notice graciously allows that Employee A will not be required to include in income under 409A any further amount solely as a result of the plan provision providing a 180-day payment period.

Contrast that example with the result when Employee B, with the same employment agreement, does not separate from service until March 30, 2011, 15 days after the amendment.  The Notice provides that, because Employer corrected Employee B's employment agreement before Employee B's separation from service, B will not be required to include any amount in income under 409A(a) solely as a result of the 180-day payment period under the pre-correction provision.