Pro-Rated Bonus Payments as Part of Severance Package

[Guest jhall]

Help. Having a problem thinking through this scenario. Company has a bonus plan they think is exempt from 409A. Provides for straight cash bonuses to be paid following close of plan year provided individuals remain employed with company through payment date. Seems clearly within the short-term deferral rule so no problems with regular bonuses.

Executive has individual employment agreement that provides for special severance package that includes immediate payout of a pro-rated amount under bonus plan assuming 100% of target at time of termination. (The payout has to be immediate so it is basically within short-term deferral exemption.) Company is currently above target performance currently. Executive is being fired. Executive thinks Company will continue to do better than target-level performance for the year. Executive would like to waive / exchange his right to immediate payout of pro-rated bonus based on target performance for a right to prorated bonus amount based on final performance for the year.

This amount would be paid out following close of the curent year but not necesarily by March 15th. Executive obviously would not have to do anything in the way of future employment to get this payout amount. However, performance could tank and leave Executive with less than the bonus amount he would get now (or even no bonus). In essence, he would give up immediate right to certain amount now in exchange for a vested right to an amount that may be greater than (or lesser than) the current amount available depending upon overall performance.

Is this a 409A issue? It seems Executive is about to vest in legal right to certain compensation. If he cold waive or amend, then he would still have a vested right at termination to an amount to be paid in the next year (deferred compensation). The amount, however, would be unknown. As such, I think the amended arrangement would need to either be exempted from 409A or have to comply. Assume for this question that the bonus amount cannot be guaranteed to be paid by March 15th so the short-term deferral exception cannot be relied upon. Also, assume that other severance eats up the separation pay exception. So, it seems this "deferral" would clearly need to comply with 409A rules.

My real question or concern is whether having executive change his "right" to pro-rated target bonus on eve of or really in connection with the vesting of that right might raise a 409A concern. On the one hand, while he has a legally binding right to that payment by virtue of his employment agreement, that right is not yet vested and would not be until he is involuntarily terminated. As such, seems he should arguably be permitted to amend these provisions before termination to provide for a different award (e.g., right to prorated bonus based on actual performance for the year rather than default target performance).

On the other hand, this looks to me a lot like making a subsequent deferral or redeferral election since he is about to reach a preset distribution trigger and he wants to push back or further defer the amounts. In this case, however, the trigger is both a vesting and a distribution trigger. Maybe that makes all the difference. I could definitely see a concern if the Executive, by virtue of the change, was simply deferring receipt of the same amount to a later year but in this situation he would be exchanging present right for potentially greater (or lesser) amount in the future. Would the provision in 409A that permits subsequent deferrals when it is for possiblity of receipt of materially greater amounts apply here? Would it apply even though there is no substantial risk of forfeiture in the sense that individual doesn't have to continue performing services. The risk of forfeiture here is simply that the amount received could be less than current amount.

[Just Me]

If he otherwise would have a right to a payment this year, but is given the option to delay it, then I think he's taking current compensation and electing to make it into 409A comp (unless it meets a short term deferral or some other exception). So I don't think subsequent deferral is the issue, but rather initial deferral. Even if it's performance-based, if it's based on 2007 company calendar year performance, it's too late to elect to defer, unless you can make some sort of "newly eligible participant" argument at this point. In addition, once he leaves, there is no longer a substantial risk of forfeiture (no continued substantial services) unless you want to go down the "subject to a condition related to the purpose of the transfer" road, which I try to avoid or tread very lightly on. The bigger issue may be whether he has constructive receipt already. We all know he's being terminated triggering a payment very soon (you just told us that), and if the company is allowing him to defer it at his request, I'd say the IRS would sure like to tax it now. "A taxpayer cannot turn his back on compensation" and all that...

[Guest jhall]

Thanks very much. This is very useful for helping think about nature of the present payment. If I'm interpreting your response correctly, seems the company could cover the 409A concern with the new election as long as it had to be paid by March 15th of 2008? That might still leave some exposure though on the constructive receipt front?

[Just Me]

Not exactly. The "new participant" election would be a very dicey approach in my mind. The employee must not have been a participant in any other account balance type nonqualified deferred compensation plan for this to be applicable, and then I'm not sure the IRS would go for it anyway. If it works, then any fixed date for payment could be specified, since it would be subject to 409A. If the payment must be made made not later than March 15, 2008, it seems like an argument could be made that there is a short term deferral (within 2½ months after the end of the year in which the substantial risk of forfeiture lapses) and not deferred compensation subject to Section 409A. However, it still is clearly a deferral of compensation into another tax year, and the "old" contructive receipt rules, which are still alive and kicking, would very likely cause the amount to be taxed this year anyway.

[Steelerfan]

Would the provision in 409A that permits subsequent deferrals when it is for possiblity of receipt of materially greater amounts apply here? Would it apply even though there is no substantial risk of forfeiture in the sense that individual doesn't have to continue performing services. The risk of forfeiture here is simply that the amount received could be less than current amount.

I would apply subsequent deferral analysis to this situation. The regs treat the deferral of an amount, for which performance of services has begun, that is about to vest as subject to the rules for subsequent modification. So the deferral looks like an initial deferal but is actually a subsequent election because the performance of services has begun. The election would have to be made within 12 months of payment, which doesn't look possible here and satisfy the 5 year rule

I would use as an analogy the vesting of restricted stock. An election to receive actual payment of the stock on a date after the vesting date, such as termination of employment, must be made either at the time of grant or 12 months before the stock vests. In your case since the election to defer was not made when the legally binding right to the compensation attached, it would have had to have been made 12 months before the right vested, which is impossible. So I'd say he has to take the scheduled payment unless the exception you mentioned applies. It's hard to say if this meets the requirement of materially greater, but it doesn't look like there is a valid SRF. Given the penalties it's hard to take the chance.

Also if this is a public company, you could jeopordize the deductibility of the payment under 162(m) if you made that sort of adjustment.

[Guest jhall]

Thanks to all. I think part of my confusion here has to do with the fact that this payment he is about to receive is really a special severance payment rather than a payment under the Bonus Plan. Although it's tied to the Bonus Plan, it's not really a payment under the terms of the plan since he wouldn't meet the continued employment requirements of that.

Would providing for an immediate payment at termination of the amount he is entitled to receive under current agreement plus a new severance benefit equal to an additional amount, if any, to be paid out in early 2008 based on actual rather than target performance work? Seems there he is not deferring or turning his back on current compensation. The additional payment is a new benefit to which he doesn't currently have any legal right. (Assume he will provide something to the company in the way of additional consideration to deserve this.) This additional severance amount would be paid before March 15th so shouldn't be a 409A issue with that.

Bifurcating the severance amount as above and making the additional amount, if any, a new severance benefit tied to actual bonus target performance would hopefully avoid constructive receipt and 409A issues. The only party harmed by this is the Company since it wouldn't get the deal originally desired--subjecting him to potential reduction in current amount if performance declines second half of the year. Given current forecast, however, I think company is willing to assume performance will remain above target level.

[Steelerfan]

I think part of my confusion here has to do with the fact that this payment he is about to receive is really a special severance payment rather than a payment under the Bonus Plan. Although it's tied to the Bonus Plan, it's not really a payment under the terms of the plan since he wouldn't meet the continued employment requirements of that.

I don't see this as any different than having such terms built into the plan. It affects the paymet of the bonus and might as well be contained in the plan. I have seen bonus plans that have incorporated such provisions--payments upon termintion before the performance period is up.

"Substitute payments" should be looked at very carefully since the IRS will look at substance over form.