Executive Compensation: How to Spot Mistakes

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1 Executive Compensation How to Spot Mistakes and Get Them Fixed Peter R. Wand Lewis Roca Rothgerber LLP (602) (office) (602) (cell) Section 409A Section 409A of the Internal Revenue Code imposes restrictions on the payment of deferred compensation. Effective Date: January 1, With very few exceptions, deferred compensation is any compensation that is earned in one year, but payable in a different year. Payments of deferred compensation must satisfy the requirements of Section 409A or the payments will be: immediately taxable (even though no money has changed hands); subject to an excise tax of 20% on the amount of the compensation; and subject to an additional interest penalty LEWIS ROCA ROTHGERBER LLP 1

2 Section 409A To avoid the immediate tax inclusion and excise taxes imposed under Section 409A, payments of deferred compensation can only be payable on one of the following triggering events: the employee s separation from service; the employee s disability; the employee s death; a fixed time or schedule; a change in control; or an unforeseeable emergency. Section 409A - Mistake No. 1 Payment Periods Longer than 90 Days Some deferred compensation agreements give the employer a fixed period of time to make the payment following the triggering event (i.e., 30 days, 90 days, etc.). This period of time could cross multiple tax years and therefore the employer has discretion as to the tax year in which the employee receives the payment. This level of discretion is a problem under Section 409A because of concerns that the employee will influence the timing of the payment. The regulations provide a 90-day rule that prevents the use of employee discretion regarding the timing of the payment LEWIS ROCA ROTHGERBER LLP 2

3 Section 409A - Mistake No. 1 Payment Periods Longer than 90 Days Under Section 409A, payments of deferred compensation must be: paid in a fixed taxable year; within a period of time that does not cover multiple taxable years; or within a 90-day period that does cover multiple years, as long as the employee has no right to designate the year of payment. Section 409A - Mistake No. 2 Severance Pay Conditioned on Release Under the 90-day rule discussed above, the employee must not have the right to designate the year of payment. This can create a problem where employers agree to severance packages for employees, but condition the payment on the employee agreeing to waive all employment claims that he or she may have against the employer. A clause of this nature may give the employee the opportunity to choose the year of the payment by returning the claims release form in the desired taxable year LEWIS ROCA ROTHGERBER LLP 3

4 Section 409A - Mistake No. 2 Severance Pay Conditioned on Release If the employer wants to include an employment claims release clause, the clause should state that if the payment can be made in different tax years dependent on when the employee signs the release, the payment will automatically be paid in the later tax year. Section 409A Mistake No. 3 Service Post-Termination A termination of employment occurs under Section 409A when the employer and employee reasonably anticipate that no further service will be performed for the company after a certain date, or that the level of services to be performed after that date (either as an employee or independent contractor) will decrease to 20% or less of the services performed by the employee on average over the prior 36-month period. When a key employee retires, the company may desire to retain the executive to provide consulting services as an independent contractor. However, under Section 409A, services as a consultant count when determining whether there has been a termination of employment LEWIS ROCA ROTHGERBER LLP 4

5 Section 409A Mistake No. 4 Taxable Reimbursements We often see plans for the reimbursement of taxable expenses that are not compliant with Section 409A, perhaps because employers do not consider this type of payment to be deferred compensation. Unfortunately reimbursements can, and often do, fall within Section 409A. Section 409A Mistake No. 4 Taxable Reimbursements A plan for reimbursements must meet the following conditions: the plan includes an objective definition of the type of payments eligible for reimbursement; the plan includes a prescribed period during which reimbursements will be made; the amount of expenses eligible for reimbursement in one taxable year will not affect amounts eligible in other taxable years; payment will be made by the end of the taxable year following the year in which the expense was incurred; and the reimbursement right is not subject to liquidation or exchange for another benefit LEWIS ROCA ROTHGERBER LLP 5

6 Section 409A Mistake No. 5 6-Month Delay - Public Companies Section 409A requires public companies to delay the payment of deferred compensation for six months, if the triggering event is a separation from service and the employee is a specified employee. A specified employee is generally one of the top 50 officers of the company. Common mistakes include the omission of the six-month delay language in the contracts of specified employees, and the failure of company (and all entities under common control) to use a consistent definition of specified employee, as required by the regulations. Section 409A Mistake No. 6 Substitute Payments When an executive is terminated, a company may seek to negotiate a severance payment that is structured differently than the severance payment in the executive's employment agreement. If the severance payment in the executive s employment agreement are subject to Section 409A, the time and form of payment cannot be changed merely by forfeiting or relinquishing rights under an old agreement for payments under a new agreement. This is considered a substitution payment under Section 409A and a substitution payment must retain the same time and form of payment as contained in the original agreement. Similarly, if a new change-in-control agreement would alter the time or form of payment that was promised in the employment agreement, the new agreement may be considered a substitution payment that violates Section 409A LEWIS ROCA ROTHGERBER LLP 6

7 Section 409A Mistake No. 7 Bonus Elections Section 409A generally provides that compensation for services performed during a taxable year may be deferred at the employee's election if the election to defer such compensation is made not later than the close of the taxable year preceding the year in which the services are rendered. However, some employers mistakenly allow employees to defer a discretionary bonus into a deferred compensation plan in the year before it is paid rather than the year before it was earned. For example, an employer announces in 2014 that it will be awarding discretionary bonuses for services performed in 2014, and will decide which employees will receive bonuses and in what amounts at the beginning of In this example, the election to defer the discretionary bonus must occur no later than December 31, 2014 not December 31, Section 409A Mistake No. 8 Noncompliant Good Reason Definition Most severance plans drafted to be exempt from Section 409A rely on the short-term deferral exemption or the separation pay plan exemption, or both. To meet these exemptions, these severance plans are drafted so that payment is dependent on the employee's involuntary termination of employment. The severance plan may also permit payment upon the employee's voluntary termination for "good reason." However, the definition of "good reason" often fails to meet the requirements of Section 409A and inadvertently the company fails the applicable Section 409A exemptions. For example, if a plan's definition of good reason does not contain a notice and cure period, then termination for good reason under that plan will not meet the requirements of the short-term deferral or separation pay plan exemptions LEWIS ROCA ROTHGERBER LLP 7

8 Section 409A Mistake No. 9 Payments Upon Death Under Section 409A, death is a permissible payment date. However, some deferred compensation plans state that payment will be made within a specified period after the plan receives notice or evidence of the death. Notice or evidence of death is not a permissible payment event under Section 409A. Accordingly, a provision that states, the Company will pay to the participant s beneficiary a death benefit equal to the amount of the participant s account in a single lump sum following receipt of notice of the participant's death would not comply with Section 409A. Section 409A Mistake No. 10 Discounted Stock Options Section 409A generally does not apply to stock options where the exercise price is set at the fair market value on the grant date. However, discounted stock options (i.e., in the money options or options with an exercise lower than the fair market value of company stock on the grant date) are subject to Section 409A. The consequence of discounted stock options being subject to Section 409A is that the optionholder recognizes taxable income as the option vests (even if the option is not exercised), unless the terms of the option comply with Section 409A (for example, the option can only be exercised at a fixed date or upon separation from service) LEWIS ROCA ROTHGERBER LLP 8

9 Base Salary The base salary earned by executives varies widely. However, even for the most highly compensated public company executives, base salary rarely exceeds $1,000,000. The $1,000,000 cap on base salary exists for three reasons: base salary earned by executive officers often sets a ceiling for the salary paid to rank and file employees; base salary earned by executive officers is often considered by rank and file employees to be a measuring stick; and Section 162(m) of the Internal Revenue Code limits the deduction available to publicly held corporations paying certain forms of compensation to $1,000,000. Section 162(m) Section 162(a): allows as a deduction all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Section 162(m): provides, in general, that in the case of any publicly held corporation, no deduction shall be allowed for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000, LEWIS ROCA ROTHGERBER LLP 9

10 Section 162(m) Covered Employees: the CEO and the 3 highest compensated officers (other than the CEO and the CFO). Applicable Employee Remuneration: All cash and noncash compensation. The following types of compensation are not subject to the limit: commissions; compensation solely payable because the employee attains performance goals if certain outside director and shareholder approval requirements are met (i.e., performance-based compensation); contributions to a qualified retirement plan (including salary reduction contributions); and amounts that are excludible from the executive's gross income (such as tax-favored employee welfare benefits). Section 162(m) Compensation is performance-based only if: it is solely paid because the executive has attained one or more performance goals; a compensation committee consisting solely of two or more outside directors set the performance goals; before payment, shareholders in a separate vote approve the terms under which the compensation is to be paid, including the performance goals; and before payment, the compensation committee certifies that the performance goals and any other material terms were met. Compensation (other than stock options and SARs) is not treated as solely paid on account of attaining performance goals unless it is paid under a pre-established objective performance formula or under a standard that precludes discretion LEWIS ROCA ROTHGERBER LLP 10

11 Annual Bonus Historically, most annual bonuses were simply disguised base salary (i.e., additional fixed compensation) and were discretionary in name only. With the proliferation of Say on Pay advisory votes and the oversight provided by Institutional Shareholder Services ( ISS ), many corporations have attempted to tie annual bonuses to corporate performance (e.g., annual cash bonus equal to.1% of EBITDA). To avoid the negative connotation associated with discretionary bonuses of the past, many corporations now refer to annual bonuses as short-term incentive payments. Long-Term Incentives Long-term incentives generally comprise the largest component of executive pay over 60% of total compensation for the median S&P 500 company. The purpose of the long-term incentive is to reward executives for achievement of the company s strategic objectives that will maximize shareholder value. These may be provided in the form of equity-based compensation (i.e., stock options, restricted stock, stock appreciation rights, and phantom stock) or cash. The performance period for a long-term incentive typically runs between three and five years, with the executive not receiving any pay from the incentive until the end of the performance period (i.e., the executive always has 3-5 years worth of unvested long-term incentives) LEWIS ROCA ROTHGERBER LLP 11

12 Stock Options Exercise: The purchase of stock pursuant to an option. Exercise price: The price at which the stock can be purchased. In most plans, the exercise price is the fair market value of the stock at the time the grant is made. Using an exercise price that is less than fair market value can create problems under Section 409A and Section 162(m) and result in adverse financial accounting treatment. Spread: The difference between the exercise price and the market value of the stock at the time of exercise. Vesting: The requirement that must be met in order to have the right to exercise the option usually continuation of service for a specific period of time or the meeting of a performance goal. Stock Options Example: Employee is granted the right to buy 1,000 shares at $10 per share. The option vests ratably over four years (i.e., 25% per year) and have a term of 10 years. If the value of the underlying stock goes up, the employee will likely exercise her option and pay $10 per share to buy the stock. The difference between the $10 grant price and the exercise price is the spread. If the stock goes to $25 after seven years and the employee exercises all options, the spread will be $15 per share LEWIS ROCA ROTHGERBER LLP 12

13 Stock Options Options are either incentive stock options (ISOs) or nonqualified stock options (NSOs). NSOs are sometimes referred to as nonstatutory stock options. When an employee exercises an NSO, the spread on exercise is taxable to the employee as ordinary income. A corresponding amount is deductible by the company. There is no legally required holding period for the shares acquired after exercise of an NSO, although the company may impose a holding period. Any subsequent gain or loss on the shares after exercise is taxed as a capital gain or loss when the optionee sells the shares. Stock Options An ISO enables an employee (i) to defer income taxation on the option from the date of exercise until the date of sale of the underlying shares, and (ii) to pay income taxes on her entire gain at capital gains rates, rather than ordinary income tax rates. Certain conditions must be met to qualify for ISO treatment: the employee must hold the stock for at least one year after exercise and for two years after grant date; only $100,000 of stock options can first become exercisable in any calendar year (any portion of an ISO grant that exceeds the limit is treated as an NSO); 2014 LEWIS ROCA ROTHGERBER LLP 13

14 Stock Options the exercise price must not be less than the market price of the company's stock on the date of the grant; ISOs can only be issued to employees; ISOs can only be granted pursuant to a written plan that has been approved by shareholders, specifies how many shares can be issued under the plan as ISOs, and identifies the class of employees eligible to receive the options; ISOs must be exercised within 10 years of the date of grant; and if, at the time of grant, the employee owns more than 10% of the voting power of all outstanding stock of the company, the ISO exercise price must be at least 110% of the market value of the stock on that date and may not have a term of more than five years. Stock Options If all the rules for ISOs are met, the eventual sale of the shares is called a qualifying disposition, and the employee pays longterm capital gains tax on the total increase in value between the grant price and the sale price. The company is not permitted to take a tax deduction when there is a qualifying disposition. If there is a disqualifying disposition, most often because the employee exercises and sells the shares before meeting the required holding periods, the spread on exercise is taxable to the employee at ordinary income tax rates. Any increase or decrease in the shares value between exercise and sale is taxed at capital gains rates. In this instance, the company may deduct the spread on exercise LEWIS ROCA ROTHGERBER LLP 14

15 Stock Options There are three basic ways to exercise a stock option: pay cash; swap company stock you already own; or engage in a cashless exercise. Cashless Exercise Methods: Standard Method A brokerage firm loans the money needed to buy the stock to the optionholder. The newly acquired shares are sold, with part of the proceeds being used to repay the loan. The proceeds (net of any withholding and brokerage commissions or other fees) are paid to the option holder. Net Cashless Exercise Method Instead of using a brokerage firm, net cashless exercise is accomplished by withholding the exercise price from the number of shares that would otherwise be delivered upon a cash exercise of the option. In effect, a number of shares will be delivered to the option holder equal to the spread on the option at exercise. Restricted Stock Restricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or employees may receive shares at no cost. However, the shares employees acquire are not vested the recipient cannot take possession of them until specified restrictions lapse. Most commonly, the vesting restriction lapses if the employee continues to work for the company for a certain number of years, often three to five. Timebased restrictions may lapse all at once or gradually. With restricted stock awards, companies can choose whether to pay dividends, provide voting rights, or give the employee other benefits of being a shareholder prior to vesting LEWIS ROCA ROTHGERBER LLP 15

16 Restricted Stock When employees are awarded restricted stock, they have the right to make a Section 83(b) election. If they make the election, they are taxed at ordinary income tax rates on the bargain element of the award at the time of grant (i.e., the difference between fair market value and payment for restricted stock). Any future change in the value of the shares between the filing and the sale is then taxed as capital gain or loss, not ordinary income. An employee who does not make an Section 83(b) election must pay ordinary income taxes on the difference between the amount paid for the shares and their fair market value when the restrictions lapse. Subsequent changes in value are capital gains or losses. A Section 83(b) election carries some risk. If the employee makes the election and pays tax, but the restrictions never lapse, the employee does not get the taxes paid refunded. SARs / Phantom Stock SARs and phantom stock are very similar concepts. Both essentially are cash bonus plans that grant employees the right to receive an award based on the value of the company s stock. SARs typically provide the employee with a cash payment equal to the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash bonus equal to the value of a stated number of shares, to be paid out at the end of a specified period of time. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible to the employer LEWIS ROCA ROTHGERBER LLP 16

17 Section 280G Golden Parachutes Many companies promise contractually to make payments or provide benefits (i.e., stock option vesting, retiree medical coverage, etc.) to executives upon closing of a merger, acquisition or other change in control or upon a termination of employment following a merger, acquisition or other change in control. These payments / benefits are commonly referred to as golden parachutes and may trigger special excise tax liabilities under Section 280G if they exceed certain limits. Section 280G Golden Parachutes Section 280G classifies payments which are contingent upon a change in control as parachute payments. If the parachute payments paid to any disqualified individual exceed three times that individual s fiveyear average taxable income (the Base Amount ), a 20% excise tax is imposed on all parachute payments in excess of the Base Amount LEWIS ROCA ROTHGERBER LLP 17

18 Change in Control Section 280G Golden Parachutes a change in ownership of the corporation s stock; a change in ownership of a substantial portion of the corporation s assets; or a change in effective control of the corporation. Disqualified Persons shareholders who own more than one percent of the fair market value of the corporation s stock; officers of the corporation; and highly compensated individuals. Section 280G Golden Parachutes Compliance Tips: Reasonable Compensation for Future Services The portion of a payment that is treated as a parachute payment can be reduced or eliminated by demonstrating with clear and convincing evidence that the payment is reasonable compensation for personal services provided after the change in control. For example, a severance agreement may provide that the disqualified individual may not compete with the corporation for a certain period of time after employment is terminated. The corporation may be able to demonstrate that all or a portion of the severance payment is reasonable compensation for the disqualified individual not to provide services to a competitor. If this can be demonstrated, the parachute payment for the severance can be reduced by the amount that is reasonable compensation for not competing with the corporation LEWIS ROCA ROTHGERBER LLP 18

19 Section 280G Golden Parachutes Compliance Tips (cont.): Reasonable Compensation for Past Services Excess parachute payments can be reduced by demonstrating with clear and convincing evidence that a portion of the excess parachute payment is reasonable compensation for services performed before the change in control. For example, when compared to similar executives at peer companies, the disqualified individual may have been underpaid in years prior to the change in control. The corporation may be able to demonstrate that all or a portion of a change-in-control bonus or other parachute payment is a catch-up payment to the disqualified individual for being underpaid in previous years. In order to reduce parachute payments or excess parachute payments for reasonable compensation, the corporation must show clear and convincing evidence that the compensation is reasonable. This may require a compensation study to determine what is reasonable LEWIS ROCA ROTHGERBER LLP 19

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