Foley & Lardner LLP. May 13, :00 p.m. 2:00 p.m. EST

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1 Attorney Advertising Prior results do not guarantee a similar outcome Models used are not clients but may be representative of clients 321 N. Clark Street, Suite 2800, Chicago, IL Foley & Lardner LLP May 13, :00 p.m. 2:00 p.m. EST 1

2 Michael H. Woolever Housekeeping Issues Call for technology assistance Dial *0 (star/zero) for audio assistance Ample time for live Q & A will be allotted at the end of the formal presentation We encourage you to Maximize the PowerPoint to Full Screen Usage: Hit F5 on your keyboard; or Select View from the toolbar menu and click Full Screen 2

3 Section 409A The Time To Act Is Now! Most businesses have at least one and in some cases many arrangements subject to Section 409A. Full compliance with final regulations under Section 409A is required by December 31, 2008 Further IRS extensions are possible, but not likely Most existing agreement will not satisfy Section 409A without amendment. Section 409A The Time To Act is Now! This presentation is designed to help you: Identify your plans, arrangements and agreements that are subject to Section 409A; and Identify potential 409A issues that need to be addressed prior to year end. 3

4 What Is Section 409A? It is the first major change in the tax law governing deferred compensation since the 1970s. Reflects concern that executives have been abusing the system (i.e., not paying taxes on compensation they control). As is often the case, when an alleged abuse is identified, Congress can over react. What Does Section 409A Do? Section 409A adds objective statutory requirements to existing legal doctrines that have governed the taxation of deferred compensation for decades. The scope of the changes made are comparable to those made by ERISA in the qualified retirement plan area. Constructive receipt, cash equivalence and economic benefit doctrines are still arguments available to the IRS Section 409A imposes significant new penalties when the statutory requirements are not met. 4

5 Does Section 409A Apply Beyond Traditional Elective Deferrals? Yes - The scope of the law is very broad With limited exceptions, any legally binding right to compensation in a future year may be covered. Legally binding means legally enforceable, not vested or non-forfeitable. For example, a discretionary bonus related to one year, but payable in the following year. Does Section 409A Apply Beyond Traditional Elective Deferrals? Section 409A covers most forms of equity and cash compensation for executives if there is a potential for deferral. Section 409A may apply to: Short and long term incentive plans, equity rights, elective deferrals, SERPS, severance benefits, reimbursement arrangements, CIC agreements; Employment agreements and other one person arrangements. 5

6 Who Is Covered By Section 409A? Section 409A covers: All employees, not just senior executives; Independent directors; Independent contractors (in some cases). When Does Section 409A Become Effective? Section 409A has been in effect since January 1, Interim IRS guidance provided fairly liberal transition rules that have minimized violations. The final regulations are effective, and transitional rules no longer apply, January 1,

7 What Does Section 409A Require The agreement, plan or arrangement must be in writing. The written document must contain all required provisions and not contain any non-compliant provisions. savings clauses are not effective What Does Section 409A Require? Deferral elections must be made on a timely basis. The time and form of payment must be specified when the election is made. Elections include unilateral employer decisions (e.g. an ad hoc award). 7

8 What Does Section 409A Require? Payments may be accelerated only by certain specified events (e.g., death, separation from service, or change in control) and only if so provided in the written document. Deferrals may be extended only if specific timing rules are followed and the additional deferral is at least five years. How May Section 409A Be Violated? Form Violations - the form of written document does not comply with 409A s requirements even if there is no benefit realized by the executive. Operational Violations -the plan, arrangement or agreement is administered contrary to its terms or the requirements of 409A. 8

9 What If Section 409A Is Violated? The deferral is ineffective for tax purposes and the deferred amounts immediately become taxable. A second tax of 20% of the amount deferred is imposed in addition to the Executive s normal tax liability. An interest penalty from the dates of original deferral is imposed. What If Section 409A Is Violated? A single violation taints all deferrals under similar plans. The types of plans that are aggregated include: Account Balance; Non-Account Balance; Separation Pay; Reimbursement; Equity Rights. 9

10 Why Should An Employer Care? Deferred compensation plans are provided as incentives. Unexpected taxes destroy the incentive. When violations occur some employers may feel obligated to make executives whole. More expensive than golden parachute gross ups. Why Should Employers Care? Executives may have legal claims for reimbursement of added taxes and the loss of deferral. Employers have reporting and withholding obligations under Section 409A. 10

11 Section 409A Employer Reporting Required to report deferrals on form W-2 or 1099-MISC. (employers must be able to identify 409A deferrals) Required to withholding when 409A violated. Not tied to payment, rather inclusion in income May in the future apply to the 20% added tax Required to report income includible under 409A on Forms W-2 or 1099 MICS Section 409A Employer Reporting Interim Reporting Rules (through 2009?) No reporting requirement for deferrals; but Withholding and reporting of 409A income. 11

12 Section 409A Tax Avoidance If the principal purpose of a plan is to achieve a result with respect to a deferral of compensation that is inconsistent with the purposes of section 409A, the Commissioner may treat the plan as a nonqualified deferred compensation plan for purposes of section 409A. IRS concerned that: Fixed rules can also lead to abuses, like in the tax shelter area; Under statute similar rights treated differently. Section 409A Exceptions Where possible, structure benefits to avoid 409A. Eliminates risk of inadvertent form or operational violations. Allows greater freedom to change provisions in the future. 12

13 Section 409A Exceptions Even where Section 409A may not apply, comply with 409A to extent possible Always clearly specify when and how payments will be made. Avoid ambiguity and discretion. Section 409A Exceptions Statutory Exceptions: Qualified plans; Broad based welfare plans; ISOs and 423 plans; Some foreign plans; Grandfathered arrangements. 13

14 Section 409A - Exceptions Key Non-Statutory Exceptions: Short-term deferrals; Non-discounted stock options and SARs; Separation pay of limited amount and limited duration following involuntary termination. Section 409A Exceptions Grandfathered Arrangements Benefits that were fully vested and nonforfeitable on December 31, 2004; and Not materially modified after October 3, 2004 (e.g. existing right enhanced or new benefit right added) 14

15 Section 409A - Exceptions Short-Term Deferrals Agreement does not provide the potential to defer payment; Payment is actually made no later than 15 th day of third month following end of the tax year. Section 409A Exceptions Short-Term Deferrals One advantage of drafting an agreement to provide for payment within the short-term deferral period is that, as long as payment is actually made during the same tax year, no violation of Section 409A will occur. 15

16 Section 409A Exceptions Short-Term Deferrals Example 1 Plan provides that the 2008 incentive award will be paid on March 15, 2009 The March 15 specified payment date is within the short-term deferral window, so the exception is available 409A does not apply to the award if it is paid by March 15, 2009 Section 409A Exceptions Short-Term Deferrals Example 2 Same facts as in Example 1, except that Employer fails to pay the award until June 30. Award is subject to 409A as it was not made within the short-term deferral window; but As the plan provides for payment on a specified date, 409A will not be violated if payment is made during the tax year which includes the specified date (e.g., 2009). 16

17 Section 409A Exceptions Short-Term Deferrals Example 3 Same facts as in Example 2, except that the plan provides that awards will be paid on or before March 15. As payment could have been made in 2008, the June 30 payment would violate 409A as the specified payment date overlaps two tax years and payment was not made within the first two and one-half months of the second year. Section 409A Exceptions Short-Term Deferrals Example 4 Same facts as in Example 2, except that the plan provides that awards will be paid during the first 90 days of Short-term deferral exception is not available; but 409A will not be violated as long as the bonus is paid in

18 Section 409A Exceptions Short-Term Deferrals Example 5 Bonus Plan is silent as to when awards will be made for the performance period ending in If payment made by March 15, 2009, 409A will not apply. If payment is made after March 15, 2009, 409A will apply; and 409A will be violated as the agreement fails to specify a time and form of payment. Section 409A Exceptions Short-Term Deferrals Example 6 Bonus Plan provides that 2008 awards will be paid within 30 days of Executive s termination of employment. Executive is terminated January 15, 2009 and paid prior to March 15, A applies as payment date could have been after March 15, Payment within the short-term deferral window alone is not sufficient when later payment possible. 409A will not be violated provided payment is made no later than the end of 2009 and executive had no right to designate in which year (2008 v. 2009) the payment was made. 18

19 Section 409A Exceptions Short-Term Deferrals Example 7 Same facts as Example 6, except that Executive s termination occurs on December 15, 2009 and payment is made on March 10, 2010 Although payment was not made within the required 30 day period, under the final regulations no violation occurs if payment is made no later than the 15 th day of the third month following the specified payment date (measured from the first day of the payment window). Section 409A Exceptions Involuntary Separation/Window Program 409A does not apply to severance pay on account of involuntary termination to the extent the payments do not exceed two times the lesser of (i) annualized compensation or (ii) the 401(a)(17) amount and payment is made in full prior to the end of the second calendar year following the year of termination. 19

20 Section 409A - Exceptions Involuntary Separation/Window Program Annualized compensation does not include bonuses, other than guaranteed bonuses of a fixed amount. The 401(a)(17) amount for 2008 is $230,000. Section 409A - Exceptions Involuntary Separation/Window Program Partial exception available even if total payments exceed limit or are payable over more than two years; but Exception not available if same or similar benefit payable without a separation from service. 20

21 Section 409A Exceptions Involuntary Separation/Window Program Example 1 - Upon involuntary termination without cause, CEO with base salary of $750,000 is entitled to $2 million payable over three years. The first $460,000 may be excluded from 409A if payable in two years or less. Section 409A would apply to the excess. Section 409A - Exceptions Involuntary Separation/Window Program Example 2 - Executive is entitled to receive $100,000 upon the earlier of (i) earnings for a year exceeding a specified target, (ii) a change in control, or (iii) involuntary termination not for cause. Section 409A applies to the full payment upon involuntary termination as it is not a pure separation benefit. 21

22 Section 409A Exceptions Involuntary Separation/Window Program Example 3 Same facts Example 1, except that payment is also due if employer elects not to extend term of employment contract even if executive continues in employment. Entire amount is subject to 409A as payment could be triggered by event other than involuntary termination. A rolling term would violate fixed payment date requirement. Section 409A Exceptions Involuntary Separation/Window Program Example 4 Same facts as Example 1, except that the severance is payable in a lump sum on termination. Payment would satisfy the short-term deferral exception. However, amending agreement to provide for a lump sum payment could violate the anti-acceleration rule. 22

23 Section 409A Exceptions Involuntary Separation/Window Program Example 5 CEO is entitled to payment of $100,000 per month for 24 months upon termination of employment for any reason as consideration for non-competition covenant. Entire amount is subject to 409A as voluntary termination could trigger right to payment. Section 409A Exceptions Involuntary Separation/Window Program Example 6 Same as Example 5 except that payment triggered by involuntary termination or his election to terminate employment for good reason. Application of 409A to the first $460,000 will depend on whether a good reason termination would be considered involuntary under the final regulations. 23

24 Section 409A Exceptions Certain Equity Rights ISOs are not subject to Section 409A, but treatment under 409A is unclear where ISOs are found to have been inadvertently issued at a discount. Restricted stock grants are normally not subject to 409A, provided there is no deferral when the restriction lapses. Section 409A Exceptions Certain Equity Rights RSUs, phantom and other equity based contract rights will normally be subject to from 409A. Time and form of payment rules will require that exercise right (or conversion of RSUs) be limited to a single tax year. 24

25 Section 409A Exceptions Certain Equity Rights Non-discounted options and SARs excluded if: The exercise or base price can never be less than FMV on the date of grant; Section 83 applies to the transfer or exercise of the option; There is no additional deferral feature; The right relates to service recipient stock. Section 409A Exceptions Certain Equity Rights IRS very concerned about potential abuses with options and SARs No material economic difference from other forms of equity rights; But legislative history supports different tax treatment. 25

26 Section 409A Exceptions Certain Equity Rights Service Recipient Stock Must be common stock for purposes of Code Section 305; May have a liquidation preference, but not other preferences; May not be subjected to mandatory puts or calls other than at FMV. Section 409A Exceptions Certain Equity Rights Service Recipient Stock Must be issued by the entity receiving the services or a controlling entity. A 50% test is used for determining control, but may go as low as 20% for valid business reasons. Issuing company may not be an investment vehicle. 26

27 Section 409A Exceptions Certain Equity Rights Additional Deferral Features A dividend right tied to exercise is treated as a price reduction which causes the option to fall under and violate 409A. A right to dividends which is not contingent on exercise will be subject to 409A, but will not taint the option. Section 409A - Exceptions Certain Equity Rights Additional Deferral Features Any right other than the right to receive cash or stock on exercise which has a deferral feature may taint the option. Cashless exercise is ok; Receipt of restricted stock on exercise is ok; Exchanging option for deferred compensation is not ok. 27

28 Section 409A Exceptions Certain Equity Rights Additional Deferral Features Example 1 Holder of stock option has the right to exchange an option for cash during a 90-day period following a change in control. Amount of cash would equal the option spread based on change in control transaction price. Downside price protection probably would bring the option within 409A. Section 409A Exceptions Certain Equity Rights Additional Deferral Features Example 2 Executive has expiring in-themoney options. Executive and Employer agree that Executive will exchange the options for a right to payment upon termination equal to the spread at the time of the exchange. Adding this right will retroactively taint the option and cause a violation of 409A. 28

29 Section 409A Exceptions Certain Equity Rights No Discount Where stock is readily traded, plan must specify how FMV is determined. E.g., last sale, closing price, mean of high and low, or average over a specified period. Special rule apply where averaging is used. Section 409A Exceptions Certain Equity Rights No Discount Where stock not readily traded, FMV must be determined through the reasonable application of a reasonable valuation method. Not reasonable if method does not take into account all available material information; Formal valuations more than 12 months old are not reasonable; Valuations less than 12 months old are not reasonable if new facts arise after valuation date. 29

30 Section 409A Exceptions Certain Equity Rights No Discount Final regulations provide presumption that certain methods are reasonable. Independent appraisal not more than 12 months old; Formula used for both compensatory and non-compensatory transactions; or Insider formal appraisal if start up No non-lapse put or call IPO or CIC not anticipated Inside qualified appraiser Section 409A Exceptions Certain Equity Rights No Discount The FMV standard in the final regulations makes the use of options or SARs in private companies problematic. Regular full appraisals with grants only in a short window after the appraisal is issued should be ok. Reliance on the last round of financing price is problematic. The use of formula prices is of limited value. 30

31 Section 409A Exceptions Certain Equity Rights No Discount Consider using options and SARs with a designated exercise window of one year or less. Executives rarely exercise options before the end of the term any way. Exercise window could be accelerated in the case of an involuntary termination of employment. Focus on options not always rationale. Section 409A Exceptions Certain Equity Rights Application of the option exception to partnership interests is up in the air Proposed and final regulations do not cover arrangements between partnerships and partners. Interim relief allows partnerships to treat partnership interests like stock. IRS continues to study this area. 31

32 Section 409A Exceptions Certain Equity Rights Modifications of equity rights can constitute new grants and cause rights to violate no discount requirement. Extension of exercise period is one such modification. Final regulations allow extensions up to original option term (if not more than ten years) on termination. May substitute similar rights in M&A transactions using ISO rules. Section 409A Requirements Requirements of 409A Written document containing all terms necessary to meet the requirements of 409A and no non-compliant terms. Timely deferral election with specified time and form of payment No acceleration (with limited exceptions) Limited right to extend deferral. 32

33 Section 409A Timely Election Timely Deferral Election General rule must irrevocably elect to defer in year prior to year that services are to be performed. Election with respect to 2009 bonus must be made in 2008 (even if bonus discretionary and even if payable in 2010). If newly eligible for plan, 30 day window to elect (but plan aggregation rules apply). If award forfeitable when granted for at least 12 months, 30 day post-grant window may also be available. Section 409 Timely Election Timely Deferral Election Performance based compensation must irrevocably elect to defer at least six months before end of performance period and before amount is readily determinable. 33

34 Section 409A Timely Election Timely Deferral Election Example Plan provides for bonus based on achieving revenues in excess of specified amount during fiscal year and provides for fixed bonus if employee dies during the fiscal year. Deferral election may be made during the first six months of the fiscal year, but only if achieving goal is not substantially certain when election made. Deferral election for death benefit must be made before performance period commences. Section 409A Timely Election Timely Deferral Election If new arrangement (e.g., initial employment agreement) election must be made when the legally binding right arises (i.e., the election must be reflected in the contract). For example, Executive enters into a retention agreement that entitles him to payment if he is still employed on third anniversary of agreement. Agreement must specify when and how payment will be made once right vests. 34

35 Section 409A Time and Form of Payment Time and Form of Payment Specific payment date or fixed schedule of payments must be specified when legally binding right arises. Specific date may be calendar year or shorter defined period. Key is to clearly define beginning and end dates. Avoid language that does not specify a objective payment window (e.g., on or before, promptly, as soon as reasonably possible ). Section 409A Time and Form of Payment Time and Form of Payment May have different payment terms based on payment trigger (e.g., death versus termination of employment), but only one form for each trigger. Special rules apply for reimbursements, in-kind benefits, and tax gross ups. 35

36 Section 409A Time and Form of Payment Time and Form of Payment Where specific date is used, payment will be deemed made on the specified date if made: Not more than 30 days prior to the specified date; On or after the specified date but within the same tax year; Within 2.5 months of the specified date. Section 409A Time and Form of Payment Time and Form of Payment Where payment period is specified, issues can arise if period covers two tax years Example 1 Executive is hired November 1 and is granted a right to a retention payment payable within 180 days of the third anniversary of Executive s employment. The payment terms violate 409A as payment need not be made in one calendar year and the payment window in more than 90 days. If Executive could elect in which year payment was made that would also be an issue even with 90 day payment window. 36

37 Section 409A Time and Form of Payment Time and Form of Payment An agreement may provide for the acceleration of payment based on the occurrence of the following events: Separation from service Death Disability Unforeseen Emergency Change in Control Plan Termination Section 409A Time and Form of Payment Separation From Service The final regulations define when a termination of employment is a separation from service. A change in legal status is not the test. Will want to include at least a cross reference to the final regulation definition in all agreements where separation triggers payment obligation. 37

38 Section 409A Time and Form of Payment Separation From Service An executive will be presumed to have separated from service if the level of postemployment services is expected to be 20% or less of the level of services provided as an employee. An executive will be presumed not to have separated from service if the anticipated level of post-employment services is expected to more than 50% of the level of services provided as an employee. Section 409A Time and Form of Payment Separation From Service Must take into consideration services for ERISA Affiliates. Executive may continue to serve on board subject to 20% rule. In asset deal parties may specify if separation occurs, but all executives must be treated consistently. 38

39 Section 409A Time and Form of Payment Separation From Service Issues as to when a termination occurs can arise in transitional situations. CEO retires, but continues as non-executive chairman CFO is removed from his position, and provides no services, but actual termination is deferred while parties negotiate terms of severance. It is important that any agreements provide clear rules as to when employment terminates for payment purposes. Need not be tied to actual termination of employment; May be a significant reduction of level of services (more than 80%), but only if plan so provides from the beginning. Section 409A Time and Form of Payment Disability The definition of disability in the regulations is very narrow unable to engage in any substantial gainful activity ; or Receiving income replacement benefits for at least three months. Generally, agreements will rely on the separation from service trigger, rather than the disability. 39

40 Section 409A Time and Form of Payment Unforeseen Emergency The narrow scope of this exclusion limits its usefulness. No other assets or ability to pay; Only amount reasonably necessary to satisfy the emergency need; Requires employer to make subjective judgment calls which increases 409A risk. Section 409A Time and Form of Payment Change In Control Final regulations define the following events which may cause payment to be accelerated: Change in ownership of corporation; Change in effective control of corporation; or Change in ownership of a substantial portion of the assets. Definitions are fairly consistent with current CIC definitions, and more liberal in some areas. 40

41 Section 409A Time and Form of Payment Change In Control Where a CIC alone triggers payment of deferred amounts, the definition in the regulations should be used (with such tightening as may be appropriate). Where the CIC triggers payment of a new benefit, following the definition in the regulations is not required, unless the CIC benefit is a substitute for another deferred benefit. Section 409A Time and Form of Payment Change In Control Where the CIC benefit has a double trigger, the CIC definition need not follow the definition in the regulations as the separation from service will be the payment trigger. 41

42 Section 409A Time and Form of Payment Change in Control Example 1 Executive has an employment agreement providing for severance following involuntary termination and a similar single trigger CIC benefit. Agreement needs to use CIC definition in regulations as CIC results in acceleration of payment of a 409A deferral (i.e., the severance benefit). Section 409A Time and Form of Payment Change In Control Example 2 Same facts as in Example 1, except that the payment is triggered only in the event of a CIC and is payable whether or not Executive s employment terminates. As the benefit is payable only upon a CIC, the employer is free to define CIC as appropriate and need not use the definition in the final regulations. 42

43 Section 409A Time and Form of Payment Change in Control May tie timing to the timing of payments to the selling entity or its shareholders provided: payments are made to the executives at the same time as payment is made to the selling entity or its shareholders, and all payments are made within five years. Section 409A Time and Form of Payment Change in Control The final regulations provide some flexibility for modifying right to CIC payment so that a specific transaction does not trigger the benefit. Must treat all executives consistently. 43

44 Section 409A Time and Form of Payment Plan Termination Termination of a plan may result in payments being accelerated only in limited circumstances: With approval of the bankruptcy court; Following a corporate dissolution; In connection with a CIC, subject to certain requirements; and If allowed by the plan, subject to certain requirements. Section 409A Time and Form of Payment Plan Termination in connection with a CIC Termination must occur within 30 days prior or 12 months following a CIC. All like-kind plans must be terminated with respect to all participants. All distributions must be made within 12 months. 44

45 Section 409A Time and Form of Payment Plan Termination/Employer Election Termination for financial reasons not allowed. All similar plans must be terminated for all participants. Distributions must be deferred at least 12 months from when termination effected. All distributions must be made within 12 months. Employer may not adopt any new plan of the same type for three years. Section 409A Time and Form of Payment Plan Termination Example: Employer A is acquired by Employer B in March Employer A has a deferred compensation plan under which executive s may elect to defer payment of a portion of their annual bonuses. Employer B may elect to terminate the Employer A plan as long as it does so before March After March 2009, the plan may only be terminated if all like kinds of plans of A and B, and other members of B s controlled group, are terminated and no new plans created for three years. 45

46 Section 409A Acceleration of Deferred Amounts Acceleration Generally Prohibited Once a legally binding right is created, a plan may not be amended to cause payment to be accelerated (other than based on permitted triggers). However, vesting of unvested rights may be accelerated without violating 409A. Section 409A Acceleration of Deferred Amounts Acceleration Generally Prohibited For example, Executive who is entitled to severance equal to 10% of his salary for each year of service up to 100% is terminated after five years when entitled to 50% severance benefit. Employer could agree to pay 100% rather than 50% (either as a new right or as an acceleration of vesting) Executive could elect a different form of payment for the newly vested 50%. 46

47 Section 409A Acceleration of Deferred Amounts Acceleration Generally Prohibited Payment of deferred amounts may be accelerated: To satisfy a domestic relations order; Under an ethics agreement with the Federal government or to avoid other violations of ethics or conflicts laws; To pay taxes under Section 457(f); To pay employment taxes (FICA); or To the extent of any recognition of income under 409A. Section 409A Extending Deferrals Rules For Extending Existing Deferrals Once the time and form of payment have been selected, payment can be deferred beyond the selected time or the form of payment changed only if: The new election is not effective for at least 12 months after it is made; The election is made at least 12 months before payment is otherwise to commence; and The additional deferral is at least five years. 47

48 Section 409A Extending Deferrals Rules For Extending Existing Deferrals Payment may also be deferred: Where payment would jeopardize the ability of the service recipient to continue as a going concern (but not merely due to a credit agreement covenant); To avoid loss of deduction under 162(m); or To avoid securities law violations. But payment must be made promptly once legal restriction or financial condition lapses. Section 409A Special Rules Reimbursements or In-Kind Benefits Part of most employment agreements. Constitute separate class of agreement under 409A. Some benefits excluded from 409A: Tax free medical reimbursements (105(h)); Outplacement fees; Moving expenses. Maximum two year reimbursement period. 48

49 Section 409A Special Rules Reimbursements and In-Kind Benefits Other benefits subject to 409A. Requirements for meeting the specified date or fixed schedule rule. Objectively determinable, non-discretionary definition of eligible expenses; Prescribed period of eligibility ( for life is ok); Eligible amount in one year can not effect right in a later year (except for overall cap in medical reimbursement plan); Reimbursement made prior to last day of tax year following tax year in which expenses incurred; No right to liquidate or exchange for another benefit. Section 409A Special Rules Reimbursements or In-Kind Benefits Example 1 Employer agrees to reimburse Executive for country club dues to a maximum of $30,000 over a three year period. Because the amount reimbursed in one year could impact the amount available for reimbursement in another year, the provision would violate 409A. $10,000 per year for three years is ok. Example 2 Same as example 1 except that the reimbursement relates to medical expenses. This provision would not violate 409A due to an exception in the regulations for medical plan caps. 49

50 Section 409A Special Rules Tax Gross Up Payments Plan must provide that reimbursement will be made prior to the end of the tax year following the tax year in which the Executive pays the related tax. Will need to review existing golden parachute payment provisions. Section 409A Special Rules Supplemental Retirement Income Plans Many large employer provide supplemental retirement benefits linked to qualified retirement plans. Historically, executives elected the form of benefit under such plans at retirement or an election under the qualified plan also operated as an election under the SERP. Under the final regulations, an executive must make benefit election at the time he commences participation in the SERP, not at retirement. 50

51 Section 409A Special Public Company Rule Specified Employees 409A requires that payments to specified employee be deferred for six months following the employee s separation from service. Specified employees are key employees under the top heavy rules of Section 416 of public companies. Includes officers and other HCEs; Generally limited to the lesser of (i) 50 employees or (ii) the greater of 3 employees or 10% of the employees. Section 409A Special Public Company Rule Specified Employees The list of specified employees will change from year to year. The regulations provide rules for determining who is a specified employee with respect to any 12 month period and following M&A transactions. Public companies will need to set up procedures to identify specified employees under these rules. 51

52 Section 409A Special Public Company Rules Specified Employees Regulations require that all agreements include the specified employee rule as of the date an employee becomes a specified employee. All public company agreement for all employees should incorporate the specified employee rule. All private company agreements need to be revised pre-ipo. Section 409A Special Public Company Rule Specified Employees Agreement should specify how and when amounts deferred by the specified employee rule will be paid. E.g., lump sum catch up payment after six months or increased payments over remaining term. If involuntary termination, up to $460,000 may be paid during six month deferral period. 52

53 Section 409A Special Public Company Rule Specified Employees No deferral is required if severance paid in lump sum meeting short-term deferral exception; but Company loses leverage to enforce postemployment covenants; Lump sum must be specified at the beginning. Section 409A Substantial Risk of Forfeiture Substantial Risk of Forfeiture Key concept under 409A. Not same as Sections 83 and 457 definitions Non-competition covenant is not SRF Obligation to sign release is not SRF Right conditioned on performance of substantial future services or the occurrence of a condition related to a purpose of compensation (i.e., a financial performance goal or specified event) 53

54 Section 409A Substantial Risk of Forfeiture Substantial Risk of Forfeiture Examples: Payment tied to occurrence of specific event e.g., CIC or stock price reaching specified level. Right to a payment subject to continued employment through a specified date. Section 409A Substantial Risk of Forfeiture Substantial Risk of Forfeiture Generally can not add SRF later or extend original term of SRF. For example, assume Executive is entitled to a payment on his third anniversary of employment. Executive agreement to extend payment date until fifth anniversary would be ineffective. May elect between cash and restricted property if restricted property more valuable E.g., may have right to elect between cash bonus and restricted stock of greater value 54

55 Section 409A Independent Contractors Independent Contractors 409A generally applies to independent contractors, but final regulations exclude ICs providing services to multiple parties. Directors always covered. Individuals providing management services are covered. Section 409A Independent Contractors Independent Contractors Dual Roles General rule If both employee and independent contractor, no separation unless both roles cease. Employee who is also director can continue as director and have separation as employee, at least with respect to non-aggregated plans. If director also provides service as an IC, both roles must cease for a separation to occur. Switching role normally does not result in separation. 55

56 Section 409A Prohibited Practices Rabbi trusts may be used to fund 409A benefits, but executives are taxable immediately if the assets are held offshore. Financial triggers may no longer be used to accelerate payment. Discretion to determine the time or form of payment after election is irrevocable. Section 409A Final Thoughts Most likely sources of 409A violations include: Failure to amend existing agreements before year end 2008; Sloppy drafting causing form violations; Failure to consider all similar plans when applying 409A to one plan (e.g., bad good reason definition in one plan taints all similar plans). Modifying agreements to change the time or form of payment. 56

57 Section 409A Final Thoughts Key Things To Remember Compliance is not hard, but inadvertent violations may easily occur. Careful drafting and plan administration are critical The consequences of violations are draconian There is no reason to get close to the line. Section 409A Final Thoughts Do Not Wait Until Year End To Address These Issues! Law firms may not have sufficient resources if everyone waits. IRS is likely to exact some penalty from those who do not meet the deadline. 57

58 Questions & Answers Michael H. Woolever Chicago, Illinois

59 Thank you for your participation. A copy of the presentation materials for this web conference, including the multimedia recording, will be available tomorrow on our website at: We welcome your feedback. Please take a few moments before you leave the web conference today to provide us with your feedback. 59