Look Out Below: Does 409A Burn a Hole in Your Golden Parachute? Examining Severance Payments Under 409A and 280G

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1 JOURNAL REPORTS: LAW AND POLICY 2005 Look Out Below: Does 409A Burn a Hole in Your Golden Parachute? Examining Severance Payments Under 409A and 280G By David C. Strosnider Chicago, Illinois JUNE 2005 Overview Section 409A 1 of the Internal Revenue Code imposes sweeping new rules on nonqualified deferred compensation arrangements. These new rules inflict steep penalties on noncompliant taxpayers and force practitioners to continually question the scope of 409A's coverage. Generally, 409A does not exempt severance plans from coverage. 2 When it comes to severance arrangements, 409A is not an executive's only cause for concern. Sections 280G 3 and of the tax code impose punitive rules on golden parachute payments. Parachute payments are compensatory payments made to disqualified individuals 5 that are contingent on a change in control where the aggregate present value of such payments equals or exceeds three times the individual's average compensation. 6 Section 280G disallows a corporate deduction and 4999 imposes a nondeductible 20 percent excise tax on excess parachute payments. 7 Severance payments may now be subject to 409A, 280G, and Executives may face a 20 percent excise tax under 4999, 8 a 20 percent penalty and retroactive interest under 409A, 9 and income tax recognition under 409A 10 or Corporations may be disallowed a deduction under 280G. 12 Poor planning can lead to unexpected and draconian outcomes. This article will examine: the coverage of severance arrangements (including change in control) under 409A; 280G and 4999, and the sections' punitive tax rules; several hypothetical scenarios that illustrate how severance arrangements can now be subject to 409A, 280G, and 4999; various techniques that limit the punitive effect of 280G and 4999; and planning opportunities that allow severance arrangements to escape coverage BNA Copyright Policy. 1

2 Introduction under 409A and avoid the imposition of severe tax penalties. On Dec. 20, 2004, the Treasury Department released preliminary guidance on 409A in Notice Generally, Notice outlined the new section's application and coverage. Notwithstanding two narrow and temporary exemptions, 14 severance arrangements are covered by 409A pursuant to the preliminary guidance. 15 Treasury did, however, request comments on 409A's application to severance plans, including whether to exclude specific types of severance from coverage. 16 Despite the request for comments, informal remarks by Treasury personnel before issuance of Notice make a broad-based exemption seem unlikely. 17 Recent informal remarks by Treasury personnel appear to evidence that guidance in the form of proposed Treasury regulations will be issued mid-summer and will address what arrangements are covered and operational issues. The next round of guidance will most likely create an exemption for severance arrangements modeled from the transitional 2005 calendar year exemptions but will eliminate complexity and be made permanent for rank-and-file employees. 18 On Aug. 4, 2003, Treasury promulgated final regulations on golden parachute payments under 280G. 19 Practitioners must be aware of 280G, 4999, and the breadth of the final regulations when structuring severance arrangements. Section 280G disallows a corporate deduction and 4999 imposes a nondeductible 20 percent excise tax on excess parachute payments. These regulations apply to excessive parachute payments that are contingent on an entity's change in ownership or control on or after Jan. 1, Section 409A now calls several common severance practices into question. Additionally, Treasury appears focused on golden parachute payments as evidenced by the department's issuance of final regulations years after 280G's original enactment. Both new and old severance arrangements must be reviewed and structured in light of 409A, 280G, and Section 409A Section 409A overlaps general tax principles that govern timing of taxation of compensatory payments. Generally, 409A applies to nonqualified deferred compensation plans and imposes rules that govern (1) the timing of distributions, (2) the prohibition of benefit acceleration, and (3) the timing of initial (or subsequent) deferral elections. 21 Plans must comply with the statutory rules in both writing and operation. 22 Unless subject to substantial risk of forfeiture or previously included in income, failure to comply with 409A causes affected plan participants to recognize immediate income tax on their deferred amounts (including credited earnings), 23 a 20 percent penalty, 24 and cumulative interest (underpayment rate plus 1 percent) on the underpayment that would result from failing to include each deferral from the date first deferred or, if later, when vested. 25 Notice and Coverage In Notice , Treasury outlined the application and coverage of 409A. 26 Treasury's definition of deferral of compensation became critical in this process. Deferral of compensation occurs only if, under the plan's terms and all relevant facts and circumstances, a service provider 27 has a legally binding right during one taxable year to BNA Copyright Policy. 2

3 compensation that has not been actually or constructively received and pursuant to the plan's terms is payable to (or on behalf of) the service provider in a later year. 28 Treasury's definition hinges on the term legally binding right. Legally Binding Right Notice defines legally binding right by elimination. Service providers do not have a legally binding right to payment and no deferral is deemed to occur when service recipients (or third parties) have a unilateral and discretionary right to eliminate or reduce the payment. 29 For a deferral to exist, there must be an enforceable promise to future compensation. If the payer has discretion to deny the compensation, no enforceable promise exists. The right to reduce or eliminate payment pursuant to objective terms (e.g., substantial risk of forfeiture) does not, however, negate a legally binding right. 30 Accordingly, if an employee can force payment by performing a discretionary act, the employee has a legally binding right (i.e., an enforceable promise). Comment: Discretion Not to Pay Disregarded if Unlikely Exercised. Apparently, Treasury was concerned that service recipients may retain faux discretion to prevent employees from having a legally binding right thereby thwarting 409A's purpose. So, Treasury adopted an anti-abuse rule. The rule provides that the discretion not to pay (or pay less) is disregarded if unlikely to be exercised. 31 Substantial Risk of Forfeiture As discussed above, a service provider does not have a legally binding right if payment can be reduced or eliminated by the service recipient. The service recipient's right to reduce or eliminate payment pursuant to objective terms of a plan creating a substantial risk of forfeiture does not negate a legally binding right. Treasury defined substantial risk of forfeiture for purposes of 409A in Q&A-10 of Notice When examining the application of 409A, practitioners must understand the definition of substantial risk of forfeiture for three reasons. First, the exception for short-term deferrals measures the 2-1/2 month period from the end of the service provider's tax year or service recipient's tax year in which there is no longer substantial risk of forfeiture. 32 Second, the failure to comply with the requirements of 409A will not result in imposition of tax penalties if the deferred compensation is subject to substantial risk of forfeiture. 33 Finally, the cumulative interest provision is imposed from the date the compensation was first deferred or, if later, when no longer subject to substantial risk of forfeiture. 34 Similar to the definition in of the tax code, Notice provides that a substantial risk of forfeiture will exist if compensation is conditioned either on the performance of substantial future services by any person or the occurrence of a condition related to a purpose for the compensation, and the possibility of forfeiture is substantial. 36 For purposes of 409A, substantial risk of forfeiture differs from 83 in the following respects: A condition related to a purpose for the compensation must relate to the service provider's performance for the service recipient or the service recipient's business activities or organizational goals (e.g., attaining a prescribed level or earnings, equity value, or liquidity event). Both the addition of substantial risk of forfeiture (after the service period has begun) and extension to substantial risk of forfeiture are disregarded. An election by the service provider to extent the period that compensation is subject to substantial risk of forfeiture is disregarded unless the amount of compensation subject to the election is substantially greater than the amount the BNA Copyright Policy. 3

4 recipient otherwise could have received. An amount is not considered subject to substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon refraining from performance of services (e.g., covenant not to compete). 37 Short-Term Deferrals The 2-1/2 Month Rule In an attempt to further define deferral of compensation, Treasury provided an exception from coverage for certain short-term deferrals. 38 Until additional guidance is issued and absent an election to otherwise defer payment to a later period, deferral of compensation does not occur if the plan requires payment and the amount is actually or constructively received by the service provider no later than 2-1/2 months after the service provider's tax year or service recipient's tax year in which there is no longer substantial risk of forfeiture (the 2-1/2 month rule ). 39 This exception allows multi-year compensation arrangements with delayed vesting to escape 409A coverage if compensation is paid within a reasonable period after vesting. Generally, severance arrangements that require payment only in the event of an involuntary termination should be treated as not subject to a substantial risk of forfeiture ( vested ) on the date of termination. Conversely, severance arrangements that permit an employee to resign for good reason (e.g., substantial change in employment responsibilities) and receive payment in such event may result in the deferral of compensation. Most likely, employees will be deemed vested upon the occurrence of the good reason event. Comment: Voluntary Termination With Payment Within Specific Time Periods. As an example of the short-term deferral rule in conjunction with a change in control, an executive signs an employment agreement that entitles him to severance if he voluntarily terminates employment with good reason within 12 months after a change in control (a double trigger change in control severance agreement). Assume the corporation experiences a change in control on Nov. 1, 2006 (and that the change in control meets the requirements of Notice ). Also, assume the executive's responsibilities are substantially reduced (a qualifying good reason pursuant to the employment agreement) on Dec. 1, The dual occurrence of the change in control and substantial reduction of his responsibilities qualify as good reason which causes the executive to vest. The executive can terminate his employment anytime from Dec. 1, 2006, through Dec. 1, 2007, and receive severance. Payments made beyond March 15, 2007 (2-1/2 months after the date CEO's rights to severance vests) would be deemed deferred compensation. Q&A-4(c) of Notice provides an example to illustrate the 2-1/2 month rule. Employer has a calendar year bonus plan and employee has a legally binding right to the payment on Nov. 1, Treasury concluded that amounts paid or made available to the employee on or before March 15, 2007, would not constitute deferred compensation.41 Treasury officials have made clear that the rule is broader than the bonus plan example and is most likely germane to other types of payments as well (e.g., severance, including change in control, arrangements). 42 Comment: Availability or Exercise of the Election. The 2-1/2 month rule is an exception based on a condition precedent. The rule applies absent an election to otherwise defer payment to a later period. 43 Unfortunately, the condition precedent is vague. The exception is clearly not available to an executive who exercised an election to defer payment. Does the 2-1/2 month rule apply when the election was available, but the executive fails to exercise? Q&A-4(c) appears BNA Copyright Policy. 4

5 to permit the inclusion of an election to defer, so long as the employee does not exercise the election. 44 Severance Agreements The statutory provisions of 409A do not exempt severance plans from coverage. 45 In Notice , Treasury confirmed that severance plans are not exempt. Treasury did narrow coverage, however, by providing two transitional exemptions for certain severance plans during the 2005 calendar year. 46 The first exemption can be satisfied by a plan that is either (1) collectively bargained or (2) does not cover key employees. 47 In addition, the plan must provide severance pay. Treasury defines severance pay by referencing the benefits provided under an ERISA safe harbor severance pay arrangement. 48 The safe harbor requires that payments are not contingent on retirement, do not exceed twice the employee's annual compensation in the year preceding termination and must be completed with 24 months of termination (longer in connection with a limited program of terminations). 49 Comment: First 2005 Calendar Year Exemption Examined. Q&A-19(d) reads a plan that provides severance pay benefits, and that is either (i) collectively bargained plan or (ii) covers no service providers who are key employees...is not required to meet the requirements of 409A during the 2005 calendar year with respect to such severance pay benefits. 50 The guidance then clarifies that benefits provided under a severance pay arrangement that satisfies the ERISA safe harbor are considered severance pay for purposes of Q&A-19(d). 51 Treasury simply appears to be defining severance pay by referencing benefits provided under an ERISA safe harbor severance pay arrangement. The exemption does not appear to be limited to severance pay arrangements. The second exemption covers payments received pursuant to an ERISA severance plan where benefit are payable only upon involuntary termination. 52 The continued use of severance provisions that do not satisfy 409A will be permissible where these exemptions apply (e.g., offering an election to terminating employee between a lump sum or periodic payments and the employee exercises). Notwithstanding the 2005 calendar year exemptions, practitioners must be aware of the plan aggregation rule that may cause otherwise exempted severance plans to be subject to 409A. Comment: The Effect of Plan Aggregation Rule. Q&A-9 describes what has been coined the plan aggregation rule. 53 The rule provides that all compensation deferred under plans of the same type is treated as deferred under a separate single plan (i.e., aggregated). 54 There are three plan types: (1) account balance, (2) nonaccount balance, and (3) other equity-based compensation. 55 Severance plans are treated as either account balance or nonaccount balance plans, 56 but typically will be treated as nonaccount balance plans because of their defined benefit characteristics. Example: Does the Plan Aggregation Rule Eliminate the 2005 Calendar Year Exemptions? Annabelle (a nonkey employee) receives a one-time, lump sum severance payment (twice her annual compensation) pursuant to a plan meeting either exemption. The receipt of severance should not be subject to 409A in the 2005 calendar year. Annabelle also participates in a Supplemental Executive Retirement Plan ( SERP ) that pays a life annuity. The plan aggregation rule would aggregate the severance plan and the SERP (i.e., both are nonaccount plans). Annabelle's participation in the SERP could deny the availability of the 2005 calendar year exemptions for three reasons. First, the aggregate value of the severance payments and the present value of the life annuity now exceeds BNA Copyright Policy. 5

6 twice Annabelle's annual compensation in the year preceding termination. Second, the payments will not be completed with 24 months of termination. Finally, payments will not be limited to involuntary terminations. The plan aggregation rule can cause severance plans that otherwise meet the 2005 calendar year exemption to be subject to 409A. Comment: Definition of Plan. Q&A-9 defines a plan to include any agreement, method, or arrangement, including an agreement, method, or arrangement that applies to one person or individual. 57 Additionally, Q&A-9 provides an agreement, method, or arrangement may constitute a plan regardless of whether it is an employee benefit plan under 3(3) of ERISA (i.e., welfare benefit plan or pension benefit plan). 58 Therefore, regardless of whether severance is received pursuant to a plan (welfare benefit plan) or an arrangement (one-time, lump-sum payment) the plan aggregation rule should apply. In April 2003, a study of 367 severance agreements revealed that 55.5 percent of the examined companies pay total salary, bonus, and equity awards for at least three years following the departure of the executive. 59 As the study illustrates, numerous severance agreements fall outside of the 2005 calendar year exemptions. Payments exceed twice employee's annual compensation in the year preceding termination and are not completed with 24 months of termination. Further, executives that received total salary, bonus, and equity awards over a three -year period would not qualify for the 2-1/2 month rule. Another study conducted in 2005 examined the severance agreements of 100 CEOs employed by Fortune 500 companies. 60 In change in control situations, the CEOs' median severance was 36 months (three times average compensation) and 80 percent was to be paid in a lump sum. 61 As the study illustrates, numerous change in control agreements fall outside of the 2005 calendar year exemptions. Payments exceed twice employee's annual compensation in the year preceding termination and are not completed with 24 months of termination. Additionally, executives who received total salary, bonus, and equity awards over a three-year period would not qualify for the 2-1/2 month rule. CEOs who receive installments would most likely not qualify for the 2-1/2 month rule. Further, severance equal to 36 months of pay would be subject to 280G and In Notice , Treasury expressly requested comments on the application of 409A to severance plans, including whether to exclude specific types of severance plan and arrangements from coverage. 62 Some practitioners have suggested an exemption of certain broad-based severance arrangements. 63 Interestingly, whether severance pay is deferred compensation was addressed prior to the issuance of guidance. 64 Treasury personnel informally commented that the big issue is whether the executive has a choice of payment methods. 65 Treasury personnel were concerned with severance plans that gave employees choice between an initial payment (full salary over one year) or payment over time (half salary over two years). 66 Having and exercising an election that affects the payment method or timing of severance may determine whether the arrangement provides deferred compensation. Comment: Will Treasury Draw a Distinction Between Severance Pay and Severance Plans? Whether severance is deferred compensation may depend upon the executive's entitlement to severance pay (one-time, lump-sum payment) or severance benefits pursuant to an ERISA severance plan. Generally, a severance plan falls within the purview of ERISA only where such BNA Copyright Policy. 6

7 undertaking or obligation requires the creation of an ongoing administrative program. 67 Courts have found an ERISA severance plan exists where an employer assumes an obligation to pay benefits on a regular basis and put periodic demands on its assets. 68 Conversely, the U.S. Supreme Court has held that one-time lump-sum payments do not constitute an ERISA plan. 69 The court stated the requirement of a one-time, lump-sum payment triggered by a single event requires no administrative scheme whatsoever to meet the employer's obligation. 70 As evidenced by Treasury personnel's informal comments, severance pay may not be deemed deferred compensation when the executive receives one-time, lump-sum payment and has no election regarding choice of payment method. Individually negotiated severance agreements that require payment upon involuntary termination without cause and which are paid within 2-1/2 months of involuntary termination will not be subject to 409A. 71 Conversely, entitlement to severance benefits pursuant to an ERISA severance plan may be deemed deferred compensation (e.g., employer assumes responsibility to pay benefits on a regular basis, executive receives payments on a periodic basis, and executive is more likely to have an election regarding choice of payment method). As supported by the recent informal comments of Treasury personnel, the next round of guidance will most likely create an exemption for severance arrangements modeled from the transitional 2005 calendar year exemptions but will eliminate complexity and be made permanent for rank-and-file employees. 72 Application of Rules Generally, the new law calls several common severance practices into question. This section of the article examines key provisions of severance arrangements that trigger the application of 409A. New and old arrangements must be reviewed and structured in light of 409A. Severance Payments Covered by 409A? For purposes of the following discussion, assume that neither 2005 calendar year exemption is available or that the plan aggregation rule will deny availability to the exemptions. (1) Legally Binding Right in Years Before Separation. We have previously examined the concept of legally binding right. When examining severance arrangements, it must be noted that objective conditions placed on payment do not prevent an employee from having a legally binding right to the compensation. Accordingly, severance agreements that require the employee to perform a discretionary act (e.g., execution of release of claims and indemnification, confidentiality agreements, or covenant not to compete) do not prevent the employee from having a legally binding right to compensation in the year the agreement is executed. It appears that when the severance payments are predicated upon a discretionary act of the employee, the payments are deferred compensation and subject to 409A unless the 2-1/2 month rule is satisfied. (2) Periodic Payments. We have also examined the temporary exception for certain short-term deferrals. Although Notice excepts short-term deferrals until additional guidance is issued, 73 recent informal remarks by Treasury personnel appear to evidence the permanency of the 2-1/2 rule. 74 For purposes of discussion, assume an employee has a legally binding right to severance payments upon executing an employment agreement. In 2006, the employee terminates. He or she would vest for purposes of 409A (not be subject to a substantial BNA Copyright Policy. 7

8 risk of forfeiture) on the date of termination. Assume both employee and employer are calendar year taxpayers and the severance agreement entitles the employee to periodic payments over a two-year period. Regardless of the 2006 date of termination, periodic payments that extend beyond March 15, 2007, would be subject to 409A. Comment: Covenant Not to Compete. For purposes of 409A, an amount is not subject to substantial risk of forfeiture merely because the right to the amount is conditioned upon refraining from performance of services. 75 Assume the employer requires the employee to sign a three year covenant not to compete on the date of termination in order to receive payment. The employee had no prior employment agreement or contract. Severance payments are made over the life of the covenant. The employee has a legally binding right to the compensation on the date he or she signs the covenant. The covenant will not, however, be treated as a substantial risk of forfeiture. Assume the employee signs the covenant in No matter when the employee signs the covenant in 2006, periodic payments that extend beyond March 15, 2007, would subject the severance agreement to 409A. (3) Exercise of Election to Defer. Assume the same facts as (2) above, however, the employee has an election to receive his severance either in a lump sum or periodically following termination. The employee elects to receive his or her favored form of payment. The 2-1/2 month rule does not apply if an employee can elect to defer compensation into a later year than the year in which the compensation ceased being subject to a substantial risk of forfeiture, and the employee exercises such election. 76 (4) Key Employees. Payments made under severance agreements and determined to be subject to 409A expose certain plan participants of public companies to the specified employees rule. 77 Upon separation of service, any distribution to specified employees (i.e., key employees of public companies) may not be made before six months has elapsed after the employee's separation from service (or upon the employee's death, if earlier). 78 Sections 280G and 4999 Parachute Payments - Generally The tax code denies deductions and imposes excise tax on excess parachute payment. Before examining this term, it is important to understand the meaning of the term parachute payment. In general, a parachute payment is any compensatory payment made to a disqualified individual 79 if contingent on a change in control (discussed below) where the aggregate present value of such payment equals or exceeds three times the disqualified individual's base amount. 80 The base amount is the individual's average compensation calculated over the most recent five taxable years (or over such period the individual performed services if shorter) ending before the date on which the change in control transpired. 81 Section 280G(b) defines excess parachute payment as the excess of any parachute payment over the portion of the base amount allocated to such payment. This can be illustrated by the following example: CEO average annual compensation (5 year average) $500,000 Safe Harbor payment* $1,499,999 Aggregate Present Value of Parachute Payment $2,000,000 BNA Copyright Policy. 8

9 Excess Parachute Payment $1,500, excise tax liability (line 4.20) $300,000 * The CEO would owe no excise tax on the payment and the employer could fully deduct the payment for federal income tax purposes. The Safe Harbor payment is calculated by multiplying line 1 by three (3) and subtracting $1.00. As illustrated above, the excess parachute payment is $1,500,000. This is the amount equal to the any parachute payment ($2,000,000) over the base amount ($500,000) allocated to such payment. Change in Control Curiously, 280G does not define its most essential concept: change in ownership or effective control of the corporation, or change in the ownership of a substantial portion of the assets of a corporation (hereinafter, change in control ). Without a change in control neither 280G nor 4999 applies. The regulations treat the definition of change in control as the occurrence of one of three events. The events include: (1) change in ownership determined by an objective test, 82 (2) change in effective control determined by two objective tests the satisfaction of either creates a rebuttal presumption based on facts and circumstances, 83 and (3) change in substantial portion of the assets of the corporation determined by an objective test. 84 Change in Ownership The regulations define change in ownership as occurring when a person (or group) acquires stock and possesses (considering the stock already owned) more than 50 percent of the total fair market value or total voting power of the corporation. 85 Once the 50 percent requisite ownership level is achieved, however, additional acquisitions of stock do not constitute new changes in ownership. 86 Change in Effective Control As described above, the regulations create a presumption that there is a change in effective control if either of these relatively objective events occurs: one person (or group) acquires (or has acquired during a 12-month period) ownership of stock representing 20 percent of the total voting power of the stock of the corporation, or a majority of the board of directors is replaced (during any 12-month period) by directors who were not endorsed by a majority of the board prior to the appointment or election of the new members. 87 The presumption is rebutted, however, only upon demonstrating that the event does not transfer the power to control (directly or indirectly) the management and policies of the corporation from one person (or group) to another. 88 Change in Ownership of Substantial Portion of Assets The regulations provide a corporation experiences a change in ownership of substantial portion of its assets when a person (or group) acquires (in a 12-month period) assets whose gross fair market value equals or exceeds one-third of the total gross fair market value of all the corporation's assets without regard to liabilities. 89 Contingent on Change in Control BNA Copyright Policy. 9

10 The phrase contingent on a change in control is essential to the operation of 280G. The One-Year Presumption - The Code Any payment made pursuant to an agreement (or an amendment to an existing agreement) entered into within one year before a change in control is presumed to be contingent on a change in control unless rebutted by clear and convincing evidence (the One-Year Presumption ). 90 Regarding amendments, the regulations do establish that only the excess portion of the payment will be subject to the One-Year Presumption (i.e., the amount increased by amendment). 91 Contingent on Change in Control - The Regulations Generally, a payment is treated as contingent on a change in control unless it is substantially certain, at the time of change, that the payment would have been made whether or not the change occurred. 92 Payments that become vested as a result of a change in control will not be treated as payments that were substantially certain regardless of the change. 93 Further, the regulations provide that payments may be contingent on a change in control regardless of whether an employee or independent contractor is voluntarily or involuntarily terminated. 94 The following payments are also treated as contingent on a change in control: the payment is contingent on an event that is closely associated with a change in control, a change in control actually occurs, and the event is materially related to the change in control. 95 Under the regulations, an event is closely associated with a change in control if the event is of a type often preliminary or subsequent to a change in control. 96 A nonexclusive list of closely associated events include: the onset of a tender offer, substantial increase in the market price of the corporation's stock within a short period, corporation's stock is removed from an established exchange; the voluntary or involuntary termination of a disqualified individual's employment, significant reduction of job responsibilities, etc. 97 An event is presumed materially related to a change in control if such event occurs within one year before or after the change in control (the Two-Year Presumption ). 98 This Two-Year Presumption may be rebutted. 99 Additionally, payments are treated as contingent on a change in control when a change accelerates the time for receiving payments that were previously vested or accelerates the vesting of a right subject to a vesting schedule. 100 With regard to acceleration of vested benefits, only the difference in the amount of the payment and the present value as of the new acceleration date is treated as contingent on a change in control. 101 Payments Not Treated as Parachute Payments There are several important exceptions to the application of 280G and Reasonable Compensation for Services Performed On or After Change in Control. Any portion of severance payments established by clear and convincing evidence to represent reasonable compensation for services rendered on or after the change in control is not treated as a parachute payment. 102 For purposes of 280G, reasonable compensation for personal services includes refraining from BNA Copyright Policy. 10

11 performance of services (such as under a covenant not to compete). 103 S Corporations, Nonpublicly Traded Companies, and Tax-Exempt Organizations. Payments made by the following entities are not parachute payments: (1) any corporation that could qualify as an S corporation immediately before the change in control regardless of whether an election was filed under 1362; 104 (2) a corporation that has no publicly traded stock if approved by 75 percent of adequately informed voting shareholders, 105 (3) a tax-exempt organization immediately before and after a change in control. 106 Reasonable Compensation Paid Before Change in Control Any portion of a payment established to represent reasonable compensation for services rendered before the change in control will constitute a parachute payment, but an exception reduces the amount of the excess parachute payment subject to tax (after being applied against the base amount). 107 This exception can best be illustrated by the following example: (1) Executive's average compensation (the "base amount") $300,000 (2) Aggregate Present Value of Parachute Payment (what executive received) $1,000,000 (3) Excess Parachute Payment (line 2 minus line 1) $700,000 (4) Compensation for Services Rendered Before Change in Control $400,000 (5) 280G(b)(4)(B) reduction (line 4 "compensation" minus line 1 "base amount") $100,000 (6) Actual Excess Parachute Payment (line 3 minus line 5) $600,000 Hypothetical Scenarios - Parachute Payments Subject to 409A and 280G Hypothetical One: CEO signs an employment contract with corporation on Jan. 1, The contract provides that CEO will receive payment of three times average pay if he terminates with good reason within 12 months of a qualifying event. The contract makes no references to change in control. On Dec. 1, 2009, the corporation experiences a change in control and substantially reduces CEO's job responsibilities (an event that qualifies as good reason under the contract). Five months after the change in control, CEO voluntarily terminates and payment is made pursuant to the terms of the contract. 409A analysis - CEO has a legally binding right to severance upon signing the contract. CEO vests in the severance payment upon the occurrence of the event that constitutes good reason. CEO receives his severance payment beyond the 2-1/2 month period that begins after the end of the vesting year (2009). The contract is subject to 409A under current guidance. The contract also violates the distribution requirements of 409A because the severance payment was made before a date that was six months after the date of separation from service as described by the specified employee rule of 409A(a)(2)(B)(i). N.B. subject to 409A under current guidance means the agreement must generally (1) impose distribution restrictions, (2) prohibit acceleration of benefits, and (3) require elections to BNA Copyright Policy. 11

12 initially (or subsequently) defer compensation both in operation and in writing, as described in Notice G and 4999 analysis - Any payment made within one year before or after the change in control is presumed to be materially related to the change in control. Unless CEO can successfully rebut the Two-Year Presumption, the payment will be treated as contingent on the change in control. Hypothetical Two: CEO enters into an employment contract with corporation on Jan. 1, The contract provides that CEO will receive payment of three times average pay if terminated within five years. The contract is amended on Jan. 1, 2005, to provide that CEO will receive three and one-half times average pay and continuation of principal benefits for three years if terminated within five years. The contract makes no references to change in control. The corporation experiences a change in control on May 1, Six months later, CEO is terminated and payment is made pursuant to the terms of the contract. Also pursuant to the contract's terms, CEO executed a release of claims and indemnification on the date of termination. 409A analysis - CEO has a legally binding right to severance upon execution of the employment contract. CEO vests on Nov. 1, 2006 (the date of termination). If he receives three and one-half times average pay as a lump sum, the severance most likely falls within the 2-1/2 month rule. Notwithstanding the lumpsum payment, CEO's receipt of continuation of principal benefits for three years would most likely fall outside the 2-1/2 month rule. The contract is most likely subject to 409A (especially if the principal benefits received are ordinarily taxable to the executive) G and 4999 analysis - Payments made pursuant to an amendment to an existing agreement entered into within one year before a change in control are presumed to be contingent on a change in control unless rebutted by clear and convincing evidence. The regulations do establish, however, that only the excess portion of the payment will be subject to the One-Year Presumption (i.e., one-half times average pay and continuation of principal benefits for three years in this example). Notwithstanding the preceding analysis, payments made within one year before or after a change in control are presumed to be materially related to the change in control. Unless CEO can successfully rebut the Two- Year Presumption, the payment will be treated as contingent on the change in control. Hypothetical Three: CEO enters into a change in control agreement with corporation on Jan. 1, The agreement provides that CEO will vest and receive payment of three times average pay if the corporation experiences a change in control. On Dec. 1, 2009, the corporation experiences a change in control when percent of its assets are acquired. CEO is not terminated. Pursuant to the terms of the agreement, CEO receives periodic payments which extend beyond March 15, A analysis - CEO receives periodic payments that do not meet the 2-1/2 month rule. The payments are subject to 409A under current guidance. It should also be noted that a distribution pursuant to this change in control (i.e., percent or more of total gross fair market value) would not satisfy the distribution requirements of 409A(a)(2)(v) that, under initial guidance, require 40 percent or more of the total gross fair market value to constitute a change in the ownership of a substantial portion of a corporation's assets. 109 For purposes of 409A, this distribution would be an impermissible trigger. The 20 percent penalty, retroactive interest, and recognition of income tax would result. BNA Copyright Policy. 12

13 280G and 4999 analysis - The payments are contingent on a change in control because CEO acquires a right to receive payment as result of a change in control that actually occurred (i.e., change in ownership of substantial portion of assets of the corporation). Hypothetical Four: CEO enters into a change in control agreement with corporation on Jan. 1, The agreement provides that CEO will vest and receive payment of three times average pay if the corporation experiences a change in control. On Dec. 1, 2009, the corporation experiences a change in control when 25 percent of the total voting power of the corporation's stock is acquired. CEO is not terminated. Pursuant to the terms of the agreement, CEO may elect to receive a lump-sum payment or periodic payments. CEO exercises his election. 409A analysis - CEO's exercise of such election violates the 2-1/2 month rule because it defers payment until later taxable years. The payments should be subject to 409A under current guidance. It should also be noted that a distribution pursuant to this change in control (i.e., 20 percent or more of the total vote) would not satisfy the distribution requirements of 409A(a)(2)(v) that require, under initial guidance, 35 percent or more of the total vote. 110 For purposes of 409A, this distribution, when 20 percent of the vote was acquired, would be an impermissible trigger. The 20 percent penalty, retroactive interest, and recognition of income tax would result. 280G and 4999 analysis - The payments are contingent on a change in control because CEO acquires a right to receive payment as result of a change in control that actually occurred (i.e., change in effective control). The example presumes that the objective test is satisfied and the presumption cannot be rebutted (i.e., the event transferred power to control the management and policies of the corporation from one person to another). Hypothetical Five: Deacon (a nonkey employee) enters into an employment contract with corporation on Jan. 1, The contract provides that Deacon will receive payment of three and one-half times average pay if terminated (involuntarily or voluntarily with good reason within 12 months) within four years. The contract makes no references to change in control. The corporation experiences a change in control on March 1, 2005, and Deacon's job responsibilities are substantially reduced. Deacon voluntarily terminates six months later, on Sept. 1, The contract requires that Deacon execute an 18-month covenant on the date of his termination. Payments are made periodically over the term of the covenant. 409A analysis - Although severance payments are made to a nonkey employee in 2005, the payments are three and one-half times the employee's average compensation and are payable on either voluntary or involuntary termination. Therefore, neither exemption found in Q&A-19(d) is applicable. Deacon has a legally binding right to payments on Jan. 1, 2003, the date he signs the employment contract. For purposes of 409A, the covenant will neither negate his legally binding right nor be treated as a creating substantial risk of forfeiture. Even if Deacon terminates employment for good reason and sign a noncompete agreement on Sept. 1, 2005 (both are discretionary acts of the service provider) and vests in the severance payments on that date, the payments are made periodically over the 18-month term of the covenant, and therefore, do not meet the 2-1/2 month rule found in Q&A-4(c). The payments are subject to 409A under current guidance. BNA Copyright Policy. 13

14 280G and 4999 analysis - Payments made within one year before or after a change in control are presumed to be materially related to the change in control. Unless Deacon can successfully rebut the Two-Year Presumption, the payments will be treated as contingent on the change in control. Comment: Covenant May Reduce Amount of Parachute Payment. Any portion of a change in control payment that represents reasonable compensation for personal services to be rendered is not treated as a parachute payment (e.g., payment attributable to covenant). In this example, assume Deacon's base amount was $200,000. The contract entitles him to $700,000 in severance. Under the regulations, Deacon must demonstrate that the covenant substantially constrains his ability to perform services and is reasonably likely to be enforced by the corporation. To eliminate the 20 percent penalty under 4999, Deacon must establish by clear and convincing evidence that the covenant represents reasonable compensation in an amount of $100,001 or more. Arguably, an 18 month substantial restriction on Deacon's ability to earn compensation should be valued at least one-half of his current annual compensation (if not more). Hypothetical Six: Emma (a nonkey employee) enters into a change in control agreement with corporation on Jan. 1, The agreement provides that Emma will vest and receive payment of three times average pay if corporation experiences a change in control. The agreement makes no reference to termination. The corporation experiences a change in control on March 1, 2005, when percent of its assets are acquired. Emma voluntarily terminates (her job responsibilities were substantially diminished) and exercises an election to receive a lump-sum payment. 409A analysis - Although severance payments are made to a nonkey employee in 2005, the payment is three times average compensation. Additionally, benefits are not payable upon an involuntary termination. Therefore, neither exemption found in Q&A-19(d) is applicable. Furthermore, Emma exercised an election with regard to form and timing of payment. The 2-1/2 month rule is not available. Section 409A would appear to be applicable under current guidance. It should also be noted that a distribution pursuant to this change in control (i.e., percent or more of total gross fair market value) would not satisfy the distribution requirements of 409A(a)(2)(v), which, under current guidance, require 40 percent or more of the total gross fair market value. For purposes of 409A, this distribution would be an impermissible trigger. The 20 percent penalty, retroactive interest, and recognition of income tax would result. 280G and 4999 analysis - The payments are contingent on a change in control because Emma acquires a right to receive payment as result of a change in control that actually occurred (i.e., change in ownership of substantial portion of assets of corporation). Hypothetical Seven: Holden becomes a participant in corporation's severance plan on Jan. 1, Only nonkey employees participate in the plan. The plan provides that Holden will receive payment of two times average pay if terminated (voluntarily or involuntarily) within four years. The plan makes no references to change in control. The corporation experiences a change in control on March 1, 2005, and substantially reduces Holden's job responsibilities. Holden voluntarily terminates with good reason six months after the change in control. The plan requires that Holden execute a release of claims and indemnification on the date of termination (i.e., Sept. 1, 2005). Severance is paid in a lump sum. Additionally, Holden participated in a SERP that pays a life annuity BNA Copyright Policy. 14

15 as the normal form of benefit. 409A analysis - The severance payment is (1) paid to a nonkey employee in 2005, (2) equal to two times employee's average compensation, (3) paid as a lump sum, and (4) on termination (voluntary or involuntary). At first blush, the severance payment made to Holden appears to satisfy the first exemption found in Q&A-19(d). The plan does not cover key employees. Additionally, the terms of the plan meet the three conditions of an ERISA safe harbor severance pay arrangement. However, the plan aggregation rule may cause the severance payment that otherwise meets the 2005 calendar year exemption to be subject to 409A because Holden's SERP life annuity, which is also a nonaccount balance plan, would be aggregated with the nonaccount balance severance plan. The SERP could deny the availability of the 2005 calendar year exemption for two reasons. First, the aggregate value of the severance payments and the present value of the life annuity now exceed twice Holden's annual compensation in the year preceding termination. Second, the payments will not be completed with 24 months of termination. The life annuity clearly does not satisfy the 2-1/2 month rule. Section 409A appears to be applicable under current guidance. 280G and 4999 analysis - Payment made within one year before or after a change in control is presumed to be materially related to the change in control. Unless Holden can successfully rebut the Two-Year Presumption, the payment will be treated as contingent on the change in control. Planning to Mitigate the Punitive Effect of Sections 280G and 4999 Corporations utilize various techniques to limit the punitive effects of 280G and Employees may pay vastly different amounts in excise tax on similar change in control events. This disparity in treatment may cause retention or incentive problems among the employees. The excise tax imposed under 4999 is directly connected to historical compensation. Younger executives are less likely vested in age-driven deferred compensation plans (e.g., SERPs), but more likely to receive large parachute payments created by accelerated vesting. Further, certain executives may have comparatively lower base amounts due to heavy participation in deferred compensation plans or may hold few or no stock options. The definition of parachute payment suggests certain planning opportunities in designing employment contracts and severance agreements. Corporations have used the following techniques to mitigate the punitive effect of 280G and 4999: (1) cap the payment, (2) pay a gross-up, (3) increase the base amount, or (4) use a best-net procedure. Cap or Clawback Provisions In some cases, change in control agreements provide a cap or clawback provision under which potential parachute payments are automatically reduced below the threshold of three times the individual's base amount. When the contingent payments equal or exceed three times the base amount, the excess payments are not made and consequently the total amount paid does not create an excess parachute payment. When this strategy is adopted, the plan should specify how the clawback amount is determined, when, and by whom. Typically, clawback provisions are contingent upon an BNA Copyright Policy. 15

16 opinion of counsel that contingent payments do not constitute reasonable compensation for future services (e.g., post-termination consulting agreements or covenants). Executives often prefer the minimum amount necessary (e.g., three times base amount less $1) to avoid imposition of the excise tax under This approach has inherent risks, however, for both the executive and the corporation. Computation errors can result in draconian results. The $1 cushion may not be sufficient and the clawback becomes operationally ineffective. Accordingly, practitioners often use the 299 percent method (e.g., 299 percent multiplied by the individual's base amount). Gross-Up Provisions Corporations will sometimes agree to gross-up parachute compensation by paying an amount sufficient to assure an executive receives a certain payment, net of the excise tax under 4999 and all other taxes. Generally, executives receive either full or partial grossups. Full gross-up provisions place the executive in the same economic position as if the excise tax (and all other taxes) did not exist. Gross-up payments themselves constitute excess parachute payments subject to excise tax (as well as regular income tax). Therefore, gross-up payments can become extremely costly. Moreover, gross-up payments are nondeductible to the paying corporation. Gross-up payments usually costs about 300 percent of the excess amount when considering the total payment to the executive, the excise tax itself, and the lost tax benefit to the corporation. Example: Corporation agrees to pay Executive A a net payment of $1,000,000. A's base amount is $300,000. The total amount Corporation will have to pay under a gross-up provision is approximately $2,350,000. The 20 percent excise tax is imposed on the excess parachute payment of $2,050,000 ($2,350,000 less $300,000) and equals $410,000. The entire $2,350,000 is subject to federal and state personal income tax and FICA. Assuming a 40 percent combined effective rate, 111 the tax result is $940,000. The net payment to A is $2,350,000 less $410,000 ( 4999 excise tax) less $940,000 (combined federal and state income tax and FICA), which equals $1,000,000. In this example, the net expense to the Corporation of the gross-up provision is $2.35 for each dollar of net benefit paid to A. Comment: Considering the Lost Tax Benefits, Corporations Pay Much More. The corporation in the above example pays $2,350,000 in aggregate parachute payments. This represents the corporation's net expense. Additionally, 280G(a) disallows the corporation's deduction for the $2,050,000 excess parachute payment. The lost tax benefit to the corporation equals $717, When the lost tax benefit and net expense are combined, Corporation is out $3,067,500. The corporation's total cost for the gross-up is approximately $3.07 for each dollar of net benefit paid to A. Partial gross-up provisions can be structured in myriad ways. Partial gross-up provisions can be structured so the excess parachute payment must exceed a set dollar amount or an amount determined by formula (e.g., 10 percent of three times base amount) to be triggered. In the event the excess parachute payments do not exceed the set dollar amount or the amount determined by formula, a clawback provision may be triggered. Further, the amount paid under partial gross-up provisions can be limited to a maximum dollar amount or percentage of the excise tax. Example: Corporation agrees to pay Executive B a net payment of $650,000. The agreement provides, however, that Corporation's obligation to gross-up BNA Copyright Policy. 16

17 payments is conditioned on excess parachute payments exceeding 10 percent of three times B's base amount. In the event the gross-up provision is not triggered, the aggregate parachute payments will be reduced below the threshold level (i.e., a conditional clawback provision). B's base amount is $200,000. Corporation's obligation to gross-up payments is not triggered in this example. The excess parachute payment is $50,001, which does not exceed $90,000 (i.e., 10 percent of three times B's base amount of $200,000). The aggregate parachute payments will be reduced pursuant to the conditional clawback provision to $599,999. Therefore, Corporation and B are not subject to 280G and 4999, respectively. Best-Net Procedure Corporations that choose not to gross-up an executive's compensation should consider adopting a best-net procedure. Under this approach, the corporation will pay 100 percent of the excess parachute payment unless it is to the advantage of the executive to receive less. Basically, two separate calculations are performed. The first calculates the amount the executive would retain net taxes (including excise) if all excess parachute payments are made. The second calculates the amount the executive would retain net taxes if parachute payments were made subject to a clawback provision (e.g., 299 percent times base amount). The executive is then paid the amount that maximizes his net-after-tax retention (i.e., best-net ). Increase the Executive's Base Amount Corporations can minimize (or eliminate) the impact of 280G by increasing the executive's base amount. As an executive's base amount increases, the amount of excess parachute payments inversely decreases. The excess parachute payment can be completely eliminated if the base amount multiplied by three exceeds the aggregate present value of all parachute payments. This planning concept requires the executive to recognize more taxable compensation than otherwise recognized in one or more base years. Corporations may attempt to accelerate income by paying bonuses in the year earned rather than after close of the taxable year (which is a common practice) or having the executive cash-out vested stock options and delay the closing of an acquisition into the next taxable year. Planning to Escape Coverage Under 409A When it comes to severance agreements, practitioners must rely on current guidance as techniques to escape coverage and limit the punitive effects of 409A. Payments made under severance agreements most likely avoid coverage under 409A by not providing employees with a legally binding right to compensation before the year of termination, not making periodic payments that extend beyond the 2-1/2 month rule, and not allowing employee to exercise an election to defer severance payments. Practitioners concerned with operational compliance or who are amending severance (including change in control) arrangements should be intimately familiar with the 2005 calendar year exemption (i.e., collectively bargained plans or plans with no key employees that meet the ERISA safe harbor for severance plans or ERISA severance plans that limit benefit payments to involuntary termination). Until further guidance is issued on severance arrangements, the best practice when representing executives may BNA Copyright Policy. 17

18 be to draft 409A gross-up provisions. Conclusion When drafting severance arrangements (including those contingent on change in control), practitioners must be aware of the application of 409A and the golden parachute provisions. Noncompliance can lead to a substantial tax penalties, retroactive interest, and denial of corporate deduction. For purposes of 409A, practitioners must have a working knowledge of the terms legally binding right and substantial risk of forfeiture, and the application of the short-term deferral exception. Until Treasury issues further guidance, practitioners should rely on Notice in structuring severance arrangements to avoid the application of 409A. Additionally, practitioners should utilize the techniques discussed herein to mitigate the punitive tax consequences of making golden parachute payments. Footnotes 1 I.R.C. 409A, added by the American Jobs Creation Act of 2004, 885, Pub. L. No I.R.C. 409A(d). 3 I.R.C. 280G. 4 I.R.C Disqualified individuals are defined in the regulations at 1.280G-1, Q&A-15, 17, 18 & 19, and discussed infra. 6 I.R.C. 280G(b)(2)(A). 7 I.R.C. 280G(a) (disallows deduction); I.R.C. 4999(a) (imposes excise tax). 8 I.R.C. 4999(a). 9 I.R.C. 409A(a)(1)(B). 10 I.R.C. 409A(a)(1)(A). 11 I.R.C. 4999(c)(2). 12 I.R.C. 280G(a). 13 Notice , I.R.B. 274, Part I. 14 Id., Part IV, Q&A-19(d). 15 Id., Q&A-3(c). 16 Id., Part III, A(1). 17 Remarks by William F. Sweetnam, Jr., U.S. Department of Treasury, Office of Tax Policy, Benefits Tax Counsel, during New 409A - Nonqualified Deferred Compensation Plans, a roundtable discussion sponsored by the Tax Management Educational Institute (TMEI), Oct. 29, 2004 ( TMEI Roundtable ) (TMEI Roundtable questions and answers BNA Copyright Policy. 18

19 appeared in BNA Tax Management Inc. Weekly Report for Nov. 8, 2004, and were reprinted electronically in BNA's Executive Compensation Library in December 2004). 18 Remarks by Daniel Hogans, U.S. Department of Treasury, Office of Tax Policy, Attorney-Adviser, during the 2005 Great Lakes Benefits Conference ( Great Lakes ) sponsored by American Society of Pension Professionals and Actuaries (ASPPA), May 5, Hogans spoke on I.R.C. 409A, Notice , and future developments. 19 Treas. Reg G-1, TD 9083, 68 Fed. Reg. 45,745, Aug. 4, 2003; corrected by TD 9083, 68 Fed. Reg. 59,114, Oct. 14, Treas. Reg G-1, Q&A I.R.C. 409A(a)(2), (3), (4). 22 Notice , Part IV, Q&A-3(c). 23 Id. 24 I.R.C. 409A(a)(1)(B). 25 Id. 26 Notice , Part I. 27 For purposes of this article, service providers are employees and service recipients are employers, although 409A also covers partners and partnerships and independent contractors. Notice , Part IV, Q&A-3(a). 28 Id. at Part IV, Q&A-4(a). 29 Id. 30 I.R.C. 409A(a)(1)(A). 31 Notice , Part IV, Q&A-4(a). 32 Id., Q&A- 4(c). 33 I.R.C. 409A(a)(1)(A). 34 I.R.C. 409A(a)(1)(B). 35 I.R.C. 83(c)(1). 36 Notice , Part IV, Q&A Id. 38 Id. 39 Id. 40 Id. 41 Id. 42 Remarks by Daniel Hogans, U.S. Department of Treasury, Office of Tax Policy, Attorney-Adviser, before the American Bar Association's employee benefits update for 2005 satellite seminar, Feb. 15, 2005 (31 Pens. & Ben. Daily (BNA), Feb. 16, 2005). 43 Notice , Part IV, Q&A-4(c). 44 Id. Notwithstanding the foregoing, if an election is provided to the service provider BNA Copyright Policy. 19

20 with respect to the taxable year in which payment of the compensation will occur, and the service provider elects a taxable year later than the taxable year in which he or she obtained a legally binding right to the payment, the arrangement constitutes a deferral of compensation subject to 409A, including the deferral election timing rules of 409A(a)(4) (emphasis added). Id. 45 I.R.C. 409A(d). 46 Notice , Part IV, Q&A-19(d). 47 Id. A key employee is defined in I.R.C. 416(i) (without regard to (5). See infra, discussing severance payments covered by 409A. 48 Id. (cross-referencing 29 C.F.R (b)(1)(i) through (iii)) C.F.R (b)(1)(i) through (iii). 50 Notice , Part IV, Q&A-19(d) (emphasis added). 51 Id. (emphasis added). 52 Id. 53 Notice , Part IV, Q&A Id. 55 Id. 56 Id. 57 Id.. 58 Id. 59 Want a big payday? Get fired by Gordon T. Anderson, CNN/Money Contributing Writer, CNN Money, April 30, 2003 (quoting a study conducted by Paul Hodgson of Corporate Library, a research clearinghouse on corporate governance issues), (last visited May 2, 2005). 60 Severance and Separation Benefits: Bridges for Employees in Transition survey analyzed by Lee Hecht Harrison and conducted by New York research firm Find/SVP, (last visited May 2, 2005). 61 Id. 62 Notice , Part III, A(1). 63 Remarks by William F. Sweetnam, Jr., TMEI Roundtable. 64 Id. 65 Id. 66 Id. 67 Schonholz v. Long Island Jewish Med. Ctr., 87 F.3d 72, 75, 28 EBC 1122, 3 EXC 37 (2d Cir. 1996). 68 McMunn v. Pirelli Tire LLC, 161 F. Supp. 2d 97, 117, 3 EXC 38(D. Conn. July 19, 2001), quoting Fort Halifax Packing Co. v. Coyne, 482 U.S. 1, 8 EBC 1729 (1987). 69 Fort Halifax Packing Co. v. Coyne, 482 U.S. 1, 8 EBC 1729 (1987). BNA Copyright Policy. 20