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Plan Participants Suing Over 409A Failures

The greatest risk from violations of the byzantine rules under Section 409A may not be from the IRS, but from the company’s own executives. I have written before on the potential risk to employers from an aggrieved employee who become subject to the 20% excise tax under Section 409A due to alleged errors by the employer (see Is This the Template for Future Lawsuits Against Employers by Executives Hit with a 409A Penalty?), but it is time for an update.

Rabbi Stanley Kroll v. Cozen O’Connor

A February 2020 case involved a participant’s claims under Section 409A. In Rabbi Stanley Kroll v. Cozen O’Connor, a federal district court for the Northern District of Illinois allowed certain of an aggrieved participant’s claims for aiding and abetting fraud to continue, while dismissing the participant’s claims for legal malpractice, aiding and abetting breach of fiduciary duty, and fraudulent concealment. Kroll had served as full-time rabbi for the Chicago Loop Synagogue (CLS) for nearly 40 years. As part of his compensation, CLS had established the Stanley E. Kroll Deferred Compensation Plan (Plan) to fund Kroll’s retirement. The Plan required the CLS to set aside annual contributions of $15,000 as deferred compensation, accruing not less than 7.5% interest per year until fully distributed to Kroll. In 2010, Kroll was provided a guaranteed schedule of benefits showing that, by December 31, 2016, the deferred compensation account would reach $866,445.95, and that, by January 1, 2020, the account would reach $1,111,177.

CLS wanted to cut expenses in 2016, and its then-president-elect asked Kroll to retire at the end of 2016. Kroll agreed and stated that he would retire on December 31, 2016. He opted to receive his deferred compensation in 15 annual installments. However, the president told Kroll on his last day that an unexplained tax issue had arisen with regard to the Plan, but she assured him that the issue would be solved. At some point after Kroll retired, he discovered that CLS had not solved the tax issue and that the Plan had not been compliant with the applicable tax regulations since 2005. The court’s opinion never mentions Section 409A, but the reference to 2005 and a 20% excise tax strongly suggests that this was the issue. CLS explained that this noncompliance meant that, “if Kroll received one penny of his deferred compensation, Kroll’s entire vested deferred compensation account would be considered income, subject to income tax, and that Kroll would have to pay an additional 20% tax as a penalty.”

Kroll also learned that CLS had not set aside sufficient funds in his retirement account to pay him as promised. Finally, Kroll alleges that, in July 2017, one of the law firm’s attorneys told him that the law firm had drafted an enforceable amendment to the Plan, effective December 30, 2016, which purported to eliminate interest on all undistributed amounts. Kroll sued CLS in 2017. The parties reached settlement in 2018. The settlement agreement included the following provision that purported to assign to Kroll any of CLS’s claims against the law firm. Kroll then sued the law firm for legal malpractice, aiding and abetting fraud, aiding and abetting breach of fiduciary duty, and fraudulent concealment, in 2019.

Illinois law prohibits the assignment of legal malpractice claims, with certain very narrow exceptions. Consequently, the court dismissed this claim. The court also dismissed the aiding and abetting breach of fiduciary duty claim, since the law firm was not a fiduciary to CLS, Kroll or the Plan, and the fraudulent concealment claim since the law firm owed no duty to Kroll. This left only the claim for aiding and abetting fraud. As to this claim, the court found that, accepting all “well-pleaded factual allegations as true” and drawing all reasonable inferences in favor of the plaintiff (as required at the motion to dismiss stage), it was at least plausible that the law firm could be found to have aided and abetted CLS’s alleged fraud to diminish Kroll’s deferred compensation by advising as to strategy, drafting an amendment, and making representations that the amendment was enforceable.

The Plan permitted CLS to amend the Plan without Kroll’s consent, but it prohibited any amendment that divested either credits to the account or rights to which Kroll would have been entitled to if the Plan had been terminated immediately prior to the effective date of the amendment.

Can it be aiding and abetting a fraud to follow a client’s instructions to amend a plan? The amendment may have been unscrupulous, but it seems to have been permitted under the terms of the Plan, at least arguably. Can it be aiding and abetting a fraud to communicate the client’s position that a plan amendment is enforceable? Perhaps if the law firm knew that statement to be unequivocally false.

The court’s decision was only to allow the case to proceed beyond a motion to dismiss. We will all have to stay tuned for further developments.

Wilson v. Safelite Group, Inc.

A 2019 case out of the Sixth Circuit Court of Appeal provides another example of the potential risk to employers from an aggrieved employee who become subject to the 20% excise tax under Section 409A due to alleged errors by the employer. The facts of Wilson v. Safelite Group, Inc. (6th Cir. 2019) are as follows. At the time of a federal tax audit in 2014, Mr. Wilson had deferred compensation totaling more than $9 million. However, the audit “revealed that some of Wilson’s elections failed to comply with 26 U.S.C. § 409A.” As a result, he owed income taxes and incurred substantial tax penalties under Section 409A.

Wilson properly submitted an election form and so became a participant in the Safelite Plan. Between 2006 and 2013, he elected to defer hundreds of thousands of dollars of compensation each year. Wilson left Safelite on July 5, 2008. By 2014, Wilson had deferred compensation totaling $9,111,384. That year, a federal audit revealed that some of Wilson’s elections failed to comply with 26 U.S.C. § 409A, a tax statute regulating deferred compensation plans. As a result, Wilson owed income taxes and incurred substantial tax penalties.

In 2016, Wilson sued the company in federal court, including state law claims for breach of contract and negligent misrepresentation, based on the company’s failure to comply with Section 409A. The company moved for partial summary judgment on the state law claims, arguing that they were preempted by ERISA.

At the Sixth Circuit, the question before the court was only whether the company’s deferred compensation plan for executive employees was an “employee pension benefit plan” under ERISA or a “bonus plan,” which would not be covered by ERISA (I also have written before on Could Your Incentive Plan be Subject to ERISA). If the plan was covered by ERISA, then the executive’s state law claims would be preempted by ERISA.

This was an easy decision for the court. Although a significant portion of the compensation that Mr. Wilson had deferred was attributable to bonus plans and payments, once deferred, the amounts clearly became part of “a plan or plans primarily for the purpose of providing deferred compensation,” and subject to ERISA.

Because the Safelite Plan qualified as an employee pension benefit plan ERISA and not a bonus plan, the Sixth Circuit affirmed the district court’s dismissal of Wilson’s complaint, leaving him no apparent remedy for the failure of the plan and the company to comply with Section 409A. It remains for others to speculate whether Wilson could have obtained relief under ERISA.

This entry has been created for information and planning purposes. It is not intended to be, nor should it be substituted for, legal advice, which turns on specific facts.