Section 409A Update. November 4, 2013 Michael Falk Winston & Strawn LLP

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1 Section 409A Update November 4, 2013 Michael Falk 2013 Winston & Strawn LLP

2 Today s elunch Presenter Michael Falk EBEC Practice Group Chicago MFalk@winston.com (312) Winston & Strawn LLP 2

3 Agenda Quick review of Section 409A Scope Rules if Section 409A applies Common exemptions from Section 409A Game Reset You Are Here State of law How has 409A changed structure, design, and behavior, in general? Correction Guidance and Opportunities M&A Best Practices 2013 Winston & Strawn LLP 3

4 Quick Review Section 409A is intended to force taxpayers to say exactly when deferred compensation will be paid Deferred compensation a contractual promise to pay (credit risk) Gov t felt ability to manipulate timing was abusive Section 409A establishes a complicated web of restrictions on deferred compensation BUT Scope of deferred compensation is exceptionally broad! 2013 Winston & Strawn LLP 4

5 Quick Review (continued) How broad is deferred compensation? Any arrangement that promises compensation in a future year, such as Salary for employee over the next three years Transaction bonus to consultant if Company is sold Stock options for director exercisable in the future Severance payable upon termination Need to develop the 409A mindset This arrangement promises future compensation, so it may be subject to 409A. Let s determine if it s exempt. If not, it must comply with all of 409A Winston & Strawn LLP 5

6 Quick Review (continued) For most companies, Section 409A issues arise in Employment agreements Severance agreements Equity and long-term incentive plans Nonqualified deferred compensation plans 2013 Winston & Strawn LLP 6

7 If Section 409A Applies May/must be paid only upon permissible payment triggers Specified date Death Disability Unforeseeable Emergency Change in Control Event Note: IPO doesn t qualify Separation from Service Six-month wait for top employees of public companies where separation from service is the trigger Several pages define terms above 2013 Winston & Strawn LLP 7

8 If Section 409A Applies (continued) Arrangement must state the time (trigger) and form of payment If participant may designate amount, time, or form of benefit, the election must be made by certain deadlines General rule is in calendar year before attributable services commence Later election dates allowed for performance-based compensation, new eligibility, etc. Once form and trigger identified, the compensation generally cannot be accelerated or further deferred 2013 Winston & Strawn LLP 8

9 If Section 409A is violated If an arrangement violates Section 409A (in form or operation) Participant, not the Company, is subject to Immediate income tax to the extent vested 20% penalty plus other underpayment penalties Company is subject to Potential reporting/withholding failures Egg on face? Some correction methods are available As discussed later 2013 Winston & Strawn LLP 9

10 Exemptions from Section 409A Qualified Plans Certain stock rights (options/sars) No discount; common stock of service recipient or higher entity; no deferral features Certain severance pay Meets conditions and up to certain limits Only available for involuntary terminations Short-Term Deferrals Pay-when-vest arrangements Pay really by March 15 of calendar year following year of vesting Vest must be a substantial risk of forfeiture Continued service through event Event related to purpose of compensation that is not substantially certain to occur 2013 Winston & Strawn LLP 10

11 Game Reset You Are Here Section 409A is alive and in effect Violations (form or operation) trigger full wrath of Section 409A penalties unless corrected under applicable guidance Section 409A penalties calculated pursuant to proposed regulations Still awaiting final regulations Chill out, California: Oct 2013: Reduces its State 20% penalty to 5% 2013 Winston & Strawn LLP 11

12 Game Reset You Are Here (continued) 409A experts still among least popular in the room Documents are longer, with many technical provisions meaningless to lay people Uncertainty regarding gray areas and likelihood of enforcement/discovery Bogeyman (so far) isn t the IRS, it s counterpart in corporate transactions 2013 Winston & Strawn LLP 12

13 Overall Effect of 409A How has 409A changed structure, design, behavior generally? Traditional nonqualified deferred compensation Still popular newly increased tax rates will only cause more demand Certain plan features now strategize for 409A To avoid hassle of determining specified employee, some public co. plans impose six-month wait on everyone To maximize distribution flexibility, use five buckets to ladder distributions Redeferral rules usually require five-year broad jump (move Year 7 distribution to at least Year 12) Companies more vigilant about plan operation 2013 Winston & Strawn LLP 13

14 Overall Effect of 409A (continued) How has 409A changed structure, design, behavior generally? Employment agreements/severance Now contain lots of 409A boilerplate Specific release timing language More conservative definitions of Good Reason/fewer walk-away windows Lump-sum severance slightly more common Post-employment COBRA or retiree medical less common and approached differently 409A indemnity? 2013 Winston & Strawn LLP 14

15 Overall Effect of 409A (continued) How has 409A changed structure, design, behavior generally? Equity compensation Stock options still popular, but more sensitive for private companies Fair Market Value methods vary for exercise price (geography, ownership) RSUs often designed to pay-when-vest Retirement vesting less common, but still out there Phantom design often has pimples If vest before payment, must use 409A change in control Often frustrating that IPO doesn t qualify 2013 Winston & Strawn LLP 15

16 409A Corrections General IRS has provided correction guidance for both: Operational errors (Notices , , & ) Document errors (Notices & ) Many corrections require one-page notice to be attached to both employee s and company s next tax returns Increase audit risk? Need good communication among internal groups (HR, Tax, etc.) Some companies more hesitant than others to use correction guidance Look to argue correction guidance not necessary Even concede violation in some cases 2013 Winston & Strawn LLP 16

17 Good News for Immature and Overripe Immature = Not yet vested Proposed income inclusion regulations give very helpful ability to correct unvested amounts Amounts are includible in income and subject to additional 409A taxes in the first year in which Amount vests (i.e., no longer subject to substantial risk of forfeiture ) AND Deferred amount is subject to a 409A error (form or operation) 2013 Winston & Strawn LLP 17

18 Unvested Amounts (continued) May self-correct while unvested Operational or document problems Helpful for discounted options/linked plans No need to use formal correction guidance or to attach notices Can t abuse it Only used to correct inadvertent errors No pattern of using rule to abuse 409A 2013 Winston & Strawn LLP 18

19 Unvested Amounts (continued) Clearly works when amount remains unvested throughout end of year What if vests later that same year? Extend vesting or add new SRF? IRS generally ignores extended vesting unless Materially greater amount Amounts would otherwise vest upon change in control event Often tests one s risk tolerance for what constitutes a substantial risk of forfeiture What if partially vested? 2013 Winston & Strawn LLP 19

20 Good News for Immature and Overripe Overripe = Closed tax years Proposed income inclusion regs concede that 409A violation in closed tax year is nonevent Example: Distribution due in 2007 was never made. Violation occurred in 2007 and can be paid now without 409A problem. Normal income tax applies Winston & Strawn LLP 20

21 Operational Errors IRS Notice , modified by and Can significantly reduce or eliminate 409A tax Remember that operational errors aggregate all other similar plans (account, nonaccount, etc.) Most common errors: Deferring too much or too little Payments miscalculated or at wrong time Regulations give some relief Within same calendar year or within 2.5 months, if later Calculation is administratively impracticable Up to 30 days early Disputed payments and settlement of disputes 2013 Winston & Strawn LLP 21

22 Operational Errors (continued) Correction method depends on When error (this year, last year, two years ago)? After second year, no correction available Who? Non-insiders have more favorable alternatives Insider is Section 16-type officer or director (applies both to public and private companies) How much? Limited amounts (under 402(g) limit) have more favorable alternatives Each correction method carries special rules regarding eligibility and regarding interest and earnings/losses. See Notices for more detail Winston & Strawn LLP 22

23 Operational Corrections Same Year Correct in same year as failure: Available for both insiders and non-insiders No 409A tax applies No notice requirement for employee Company still must include notice on its tax return 2013 Winston & Strawn LLP 23

24 Operational Corrections Same Year (continued) Failure to defer or payment at least one tax year too early Employee must contribute/repay amount to the plan Non-insiders have up to 24 months Insiders must pay during that year Pay too early within year or violate six-month delay rule Employee must repay amount to the plan Payment then delayed beyond original date by number of days employee had the money 2013 Winston & Strawn LLP 24

25 Operational Corrections Same Year (continued) Excess Deferral Plan must distribute Stock Rights If unintentionally discounted, may adjust price up to at least grant-date FMV Again, for these same-year corrections Available for both insiders and non-insiders No 409A tax applies No notice requirement for employee, but company must include notice on its tax return 2013 Winston & Strawn LLP 25

26 Operational Corrections Next Year Correct in following taxable year: Only for non-insiders No 409A tax applies Notice requirement on tax returns of both employee and company 2013 Winston & Strawn LLP 26

27 Operational Corrections Next Year (continued) Failure to defer or payment at least one tax year too early Repay back to the plan Paid too early within year or violated six-month rule Repay back to the plan and then wait for period equal to number of days by which original payment was too early 2013 Winston & Strawn LLP 27

28 Operational Corrections Next Year (continued) Excess deferral or failure to distribute Distribute amount from plan Stock Rights If unintentionally discounted, may adjust price up to at least grant-date FMV Again, for these next year-corrections Only available for non-insiders No 409A tax applies Notice requirement for both employee and company 2013 Winston & Strawn LLP 28

29 Operational Corrections Next Two Years Correct within two years following failure: Available for both insiders and non-insiders Additional 20% tax applies on that amount But no premium interest No aggregation of other amounts May require amended W-2 and tax return Notice requirement on tax returns of both employee and company No provision for stock right corrections 2013 Winston & Strawn LLP 29

30 Operational Correction Example Assume in 2013 a company finds an operational error. Plan was supposed to distribute five separate annual installments beginning in Hasn t paid anything yet and 2014 Payments? 2013 Payment? 2012 Payment? 2011 Payment? 2013 Winston & Strawn LLP 30

31 Document Errors Remember: No aggregation: document error doesn t taint similar plans Once deferred comp, always deferred comp Correction Guidance: Correction allowed only for errors listed in the guidance. No others. Stock rights and linked plans generally not correctible Similar notice requirements on tax return (company and employee) Onerous look-back requirements Creates suspense! Will there still be 409A tax? Alternatives outside correction guidance? Is it exempt? Then not a correction General contract provisions? 2013 Winston & Strawn LLP 31

32 Document Errors (continued) allows informal corrections for minor document problems No need to do filings. No look-back. Not a violation. As soon as practicable No problem as long as it follows a permissible payment trigger ( PPT ) Ambiguous definition or no definition Document complies if savings clause No document violation as long as interpreted consistently with PPT 2013 Winston & Strawn LLP 32

33 Document Errors (continued) Bad definitions of otherwise PPT Amend to correct the definition If bad trigger happens within 12 months, then 409A tax applies to some portion of the plan benefit Bad definition of separation from service : 50% subject Bad definition of change in control or disability: 25% Bad payment periods following PPT (too long a period or impermissible employee discretion, such as an unlimited release period) If fix before PPT occurs, no portion subject to 409A tax If fix after PPT occurs, 50% subject to 409A tax 2013 Winston & Strawn LLP 33

34 Document Errors (continued) Multiple triggers: some good PPTs, some bad Remove bad trigger If bad trigger happens within 12 months, 50% subject to 409A tax Only bad triggers Remove all bad triggers and replace with later of separation from service and six-year anniversary of correction 409A tax automatically applies to 50% of the benefit Multiple schedules/time form of payment and employee discretion Amend to eliminate all but the latest If triggering event happens within 12 months, 50% subject to 409A tax Impermissible Employer discretion to accelerate payment Amend to eliminate discretion before exercised 2013 Winston & Strawn LLP 34

35 Document Errors (continued) Bad language regarding in-kind benefits Amend language If event that would trigger benefit occurs within 12 months, 50% subject to 409A tax Document fails to include six-month delay Amend before applicable separation from service to provide for payment on later of 18 months following correction or six months from separation from service If separation from service occurs within 12 months, 50% subject to 409A tax Big help? Any document error can be corrected within first year of new plan Winston & Strawn LLP 35

36 Audits and Cavity Searches IRS audit activity minimal to date Early Information Document Requests sought information about SRFs and short-term deferrals Difficult at times to know whether a plan is subject to Section 409A (that is we think it s exempt but it complies anyway ) Cavity searches occur in corporate transactions Buyer, lender, etc. Valuable to self-audit, categorize and correct or amend documents ahead of transaction rush Typical reps/warranties 2013 Winston & Strawn LLP 36

37 M&A Issues Exempt animals are your friends (great flexibility) Short-term deferrals Stock rights (options) Exempt severance If substituting stock options, need to comply with 409A rules (e.g., ratio test) Is there a change in control or separation from service? Earn-outs Special rule allows plan termination upon 409A change in control 2013 Winston & Strawn LLP 37

38 Best Practices Educate everyone: No compensatory document goes out without 409A review Adopt an overarching 409A Policies and Procedures document to fill in gaps Design for exemption! Short-term deferrals, severance exemption, stock rights Simplifies corrections and gives more flexibility to eliminate, amend, accelerate, etc. Watch out for Retirement trap! Include change in control as payment trigger or rely on termination rule? 2013 Winston & Strawn LLP 38

39 Best Practices (continued) If allowing participant elections, dissect election forms to avoid errors What compensation? (Bonus, annual, plan name) New elections affect existing deferrals? Complying with deferral timing rules? Example: really performance based / newly eligible? What if compensation changes during year? Preemptively compliant stock options For private companies Does it really change behavior? 2013 Winston & Strawn LLP 39

40 Contact Information Michael Falk EBEC Practice Group Chicago (312) Buy my book! Practical Guide to Code Section 409A (CCH, 2012) Holidays will be here before you know it! 2013 Winston & Strawn LLP 40

41 2013 Winston & Strawn LLP 41 Questions?

42 2013 Winston & Strawn LLP 42 Thank You.

43 Required Circular 230 Notice: Any Federal tax advice contained herein is not written to be used for, and the recipient and any subsequent reader cannot use such advice for, the purpose of avoiding any penalties asserted under the Internal Revenue Code. If the foregoing contains Federal tax advice and is distributed to a person other than the addressee, each additional and subsequent reader hereof is notified that such advice should be considered to have been written to support the promotion or marketing of the transaction or matter addressed herein. In that event, each such reader should seek advice from an independent tax advisor with respect to the transaction or matter addressed herein based on the reader s particular circumstances Winston & Strawn LLP 43