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It’s no surprise that many general counsel have paid scant attention to the latest nuances of the Internal Revenue Service’s interpretation of section 409A of the Internal Revenue Code, which governs taxation of nonqualified deferred compensation plans. They’ve got other pressing matters to worry about. And human resources and benefits departments generally handle these matters well. But in-house counsel can’t afford to ignore these tax rules when it comes to executive compensation. Congress added section 409A to the tax code in October 2004, largely in response to perceived abuses by Enron Corp. Selected executives at Enron were permitted to put salary, bonuses, and long-term compensation, on a tax-deferred basis, into nonqualified deferred compensation plans. In the few months before declaring bankruptcy, the energy giant allowed many of these executives to accelerate payments from these plans. But while the executives were cashing in, other employees were unable to access their company stock matching account balances, after a change in 401(k) plan vendors, just as Enron stock plummeted. Section 409A penalizes this type of perceived abuse by limiting when participants may access benefits under a nonqualified deferred compensation plan. Employees generally can no longer elect to accelerate payments from these plans. Section 409A significantly restricts the ability to further defer scheduled payments. In addition, payments to certain key employees on account of leaving a public company must be delayed for six months after separation from service. If these restrictions are violated, all amounts that are vested immediately become subject to income tax, even if the employee has not actually received any payment. The IRS will also impose a 20 percent additional tax on the vested amount now subject to tax and will charge interest from the vesting date. In September the IRS issued 238 pages of proposed regulations further interpreting section 409A. While HR departments have grappled with these changes, chief legal officers are largely unaware of them. This is a dangerous blind spot for general counsel negotiating severance agreements for departing executives and other key employees. Consider the scenario in which you, the GC of a public company, have been asked to prepare a severance agreement for an executive officer. The agreement calls for salary and bonus continuation tied to a three-year noncompete agreement with an extended stock option exercise period. This is a common arrangement, and it raises significant 409A issues. If you aren’t aware of section 409A when preparing such an agreement, the executive may well end up with a whopping tax bill. That’s because the IRS has interpreted the law to cover many arrangements that have not traditionally been considered to be deferred compensation. According to guidance from the IRS and the proposed regulations, any arrangement � other than a tax-qualified retirement plan that defers taxable compensation for more than a year � is generally subject to section 409A. As such, arrangements covered by section 409A include not only the type of nonqualified plans identified by Congress in Enron, but also, depending on the circumstances: Continued salary and bonus payments after employment termination. Stock options and variations of stock options that pay the option value in cash, commonly referred to as stock appreciation rights. Dividends on stock granted to an employee that are subject to a vesting requirement. Rights to receive a deferred payment of stock at a later time that are subject to a vesting requirement. Incentive plans that pay bonuses more than two-and-one-half months after the end of the performance period for the bonus. Certain reimbursement arrangements provided to employees that are provided for extended periods. Discriminatory retiree medical plans that are self-funded by the employer. Insurance arrangements that permit employees unrestricted access to cash surrender values. Rules determining what falls under section 409A provisions deserve close attention. They are very complicated and not intuitive. Severance, for example, may fall under section 409A, but in some cases it does not. It all depends on variables, including the nature of the employment termination, the severance amount, the payment schedule, and when the executive earned a right to severance. It’s important to know whether section 409A applies to severance, as certain payments to certain officers at public companies and their affiliates will need to be delayed for six months. Similar complexities exist for stock options and stock appreciation rights. Changes to a stock right after the grant date may result in a section 409A violation. Employers commonly amend stock rights after the grant date, extending the exercise period as part of a negotiated separation agreement, reduction in workforce, or retirement. Extended exercise periods often range from one to three years after the employment termination. Under the proposed regulations, adding an extended exercise period will violate section 409A unless the extension does not last past the end of the current calendar year or two-and-one-half months, whichever is longer. There can also be problems with stock options and stock appreciation rights even if a change isn’t made. An exemption for stock options and stock appreciation rights is available under section 409A, but only if the strike price is no less than the stock’s fair market value on the grant date and the stock qualifies for the exemption. Inadvertent discounts due to an error in identifying the grant date or determining the stock’s value may result in a section 409A violation. The proposed regulations also provide that preferred stock and non-traded stock of a subsidiary held by a public company cannot be used for exempt stock option grants. Executives and their advisers are beginning to address section 409 up front in the negotiation of both employment agreements and severance arrangements. That’s because it is the executive who will primarily suffer the tax consequences of any violations. Some companies, aware that they could create significant ill will with key executives or even be sued, are going to great lengths to protect executives from inadvertent violations. Employers are also realizing their responsibility for reporting and withholding taxes and interest for section 409A violations. Some employers have accommodated requests from executives to cover the cost of section 409A violations through tax gross-up payments. But companies must decide whether to extend this coverage if the executive intentionally violates section 409A contrary to plan documents. Other employers have taken the opposite approach, specifically stating that the employee is solely responsible for the consequences of any 409A violation. The broad scope of section 409A and its costly consequences require close attention. Compensatory arrangements providing for deferred payments should be reviewed for section 409A compliance by tax counsel, both now and when final regulations are issued later this year. Agreements now being drafted should be written with section 409A in mind. Existing plans may need to be amended to correct potential problems. Under the proposed regulations, employers can amend plans to comply with section 409A until the end of 2006. Although companies are paying attention to section 409A, they may not be aware of the wide range of situations in which it applies. Failure to recognize this can cause significant tax penalties for employees that will be difficult to remedy after the fact. Andrew Liazos is a partner in the Boston office of McDermott Will & Emery. He heads the Boston employee benefits practice and the firm’s executive compensation group.

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