Modifying Good Reason provisions

[Guest Perseo]

I am puzzled by the guidance in the Sept. 10 release, IRS Notice 2007-78. The release identifies an issue I had been worried about, but then gives what I think is logically circular guidance.

The issue relates to an arrangement that would constitute a substantial risk of forfeiture under 409A (and so would be excluded) but for the fact that it has a "good reason" provision which does not comply with the safe harbor and otherwise may or may not qualify as good reason under the non-safe harbor rules of TR 1.409A-1(n). The question is whether we can amend the good reason definition to ensure that it meets 1.409A-1, so we are then sure that the arrangement is excluded from being a 409A deferral. The subtle issue is that, in theory, an amendment to "good reason" could be changing an arrangement that under current terms is not subject to a substantial risk of forfeiture into one that is, and the IRS guys have been extremely hostile to the idea that SRF can be reimposed or extended by agreement of company and executive (viewing that as so economically non-sensical as to be a sham).

Here is what Notice 2007-78 says:

"The Treasury Department and the IRS understand that taxpayers may desire to conform existing good reason conditions to the requirements of the definition of an involuntary separation from service under the regulations. Accordingly, to the extent that a right to a payment subject to an existing good reason condition is subject to a substantial risk of forfeiture, the modification of the good reason condition on or before December 31, 2007 to conform to some or all of the conditions set forth in § 1.409A-1(n)(2) will not be treated as an extension of the substantial risk of forfeiture. However, if the right to a payment subject to existing good reason conditions is not subject to a substantial risk of forfeiture, the modification of such condition to include one or more of the conditions set forth in § 1.409A-1(n)(2)(ii), or to remove one or more of the existing good reason conditions, will not cause the amount to be treated as subject to a substantial risk of forfeiture."

This seems to me to say "if your arrangement, including the good reason definition, does not constitute an SRF already, you can't change good reason so as to fix it, but if it does constitute good reason already, then you can change good reason in ways that move the definition closer to 1.409A-1(n)." If so, this is worthless. If I was so sure my good reason definition was OK, I would have little need to amend it. It is the good reason definitions that are out of compliance that I need to fix the most.

I can read this slightly differently, I suppose. This reading depends on what the meaning of "is" is, to quote Bill Clinton. Say I have a good reason definition that says that, after a Change in Control of the company (as defined), the executive will have a walk-away right for one year. That definitely is not a good conforming definition of "good reason." However, no CiC has yet occurred, so at the moment the arrangement is subject to a substantial risk of forfeiture (assuming that the CiC condition by itself is a "condition related to a purpose" of the business). Does the new guidance mean I can fix this one, but could not have fixed it if the CiC had already occured so that the walk away right was currently exercisable? This approach still leaves me hanging for fixing a pre-CiC good reason definition, such as one that has no cure provision, unlimited time to pull the trigger if good reason is created, or any of the other things that we see to fix in good reason definitions.

Is there some other way of looking at this to conclude that good reason provisions can be fixed so as to confirm the righteousness of a substantial risk of forfeiture?

[Guest Perseo]

At least one commentator thinks the IRS was trying to provide relief on my issue. In a Gibson Dunn blurb on Notice 2007-78, they say:

Beginning January 1, 2008, it generally will not be possible to amend

overbroad definitions of good reason to bring them within the safe

harbor or otherwise make them equivalent to an involuntary termination

provision, thereby precluding the use of the "short-term deferral rule"

or the "two year, two times" rule to pay out severance to specified

employees of public companies without having to impose a six-month

delay. However, the Notice appears to provide that it generally is

permissible to change the good reason provision by December 31, 2007 and

have the desired effect with respect to terminations of employment that

occur after that date. Thus, employment agreements and other

arrangements with overbroad good reason provisions need to be revised by

December 31, 2007 if there is a desire to avoid or limit the application

of Section 409A to severance payments under those agreements and

arrangements.

I hope they are right.

[namealreadyinuse]

Yes, it is just an effective date issue as to whether or not you are under the final regulations.

I think that they are just clarifying their position that they don't allow you to add a new SRF (essentially extending a SRF). If final regs say your good reason is not SRF, you have to amend before 1/1/08. Isn't it that simple, assuming of course that you have some good faith basis for arguing that your non final reg good reason definition is good enough for transition period SRF.

[Steelerfan]

If final regs say your good reason is not SRF, you have to amend before 1/1/08. Isn't it that simple, assuming of course that you have some good faith basis for arguing that your non final reg good reason definition is good enough for transition period SRF.

Close.

There are two distinctions the IRS is making, one is between whether your current good reason is SRF or not, and the other is whether it is safe harbor SRF or not (assuming there is an SRF). If the former applies (i.e. not SRF), you cannot amend (ever); if the latter applies (i.e. non safe harbor SRF), you can amend before 1/1/08.

My understanding of the regulations is that it would be possible (even after 1/1/08) to have a non-safe harbor good reason that creates an SRF, but there would be enough doubt to cause chronic back and neck pain, with sciatica and carpal tunnel (thus the comfort of the safe harbor). So what the IRS is saying is that your current non safe harbor definition must create a valid SRF; if it does not you will not be able to amend it to make it safe harbor, even before 1/1/08, because you lost your SRF (and can never get it back).

The trick is being certain that the non safe harbor definition creates an SRF. You're on your own there.

[Guest Perseo]

I read it the way you do, Steelerfan, although if you have a non-safe harbor good reason provision, you can amend it to be safe harbor compliant, but the sciatica and painful rectal itch won't really go away because you will always wonder whether your original good reason defintion was in fact a good SRF.

Making the good reason definition safe harbor compliant only does two things -- it buries it a little deeper in the files, and arguably a good reason definition can work in 2007 if it is only good faith compliant, while in 2008 and later it has to be strictly compliant. That may in fact be a pretty big advantage.

[namealreadyinuse]

I think we are all on the same page, but don't we have more discretion in 2005-07 to determine whether somehting is a SRF?

What if we have a document provision that would not be a 409A SRF in our document ("ANY reduction in TOTAL compensation and benefits") for example, but everything was administered in good faith compliance with 409A and that provision was effectively ignored from 2005-2007. Under the Notice it sounds like it cannot be amended to comply with 409A good reason. Is that correct?

[Guest Perseo]

Interesting thought. Most of my thinking to the effect that we are administering in good faith compliance regardless of what the documents say -- during the 2005-07 period -- has focused on full-fledged 409A deferrals. This concept is that we really would ignore the bad aspects of a good reason definition during the transition period so that we really always had an SRF. Hard to believe, given that we did not even know what part of good reason was bad until April 2007, and that the executive would have to agree to give up a substantial right to get that result, but I like the argument.

I have focused further on my main issue, and found that the IRS said more. My quotation above was from page 19 of Notice 2007-78. Reading on, on page 20, the Notice points to the ability to elect new distribution dates during the transition period, and says this flexibility would allow a deferral arrangement to be modified during 2007 (with 2008 and later effect, as we all know) to qualify for a 409A exclusion, mentioning the 2-year/2-times exclusion in particular.

So, for example, say my severance is payable upon an involuntary separation and upon a retirement -- so it does not qualify for the 2-year/2-times relief. In 2007 we can modify it to provide for payment only upon an involuntary separation (of course, this would be dumb for the executive to agree to, but it is just an example). A change to a good reason definition to bring it within 1.409A-1(n) would be the same kind of thing, and the change might be less dramatic so an executive could rationally agree to it.

This is helpful, but I am still confused. In the final regulations, it is stated that a payment made solely upon an involuntary separation constitutes a substantial risk of forfeiture. In the Notice, it says we can modify an arrangement to make it payable solely upon an involuntary separation, and in that way qualify for 409A exclusions. I thought the short-term deferral rule was an "exclusion," too. However, at page 19 of the Notice I am told (pretty clearly I now believe) that, if my separation arrangement is not already subject to an SRF, I cannot reimpose SRF.

So, maybe the IRS is saying that we cannot in 2007 modify a bad good reason definition (assuming no other terms impose an SRF) to make it a good good reason definition and thereby change a full-fledged deferral to a short-term deferral, but we can modify the bad good reason definition to qualify for the 2-year/2-times exclusion.

[Chaz]

If the agreement was in existence before January 1, 2005, and has not been materially modified since, if there is a "bad" good reason definition and thus no SRF, can't the amount be considered accrued and vested before the effective date of 409A and therefore grandfathered?

[Steelerfan]

This is helpful, but I am still confused. In the final regulations, it is stated that a payment made solely upon an involuntary separation constitutes a substantial risk of forfeiture. In the Notice, it says we can modify an arrangement to make it payable solely upon an involuntary separation, and in that way qualify for 409A exclusions. I thought the short-term deferral rule was an "exclusion," too. However, at page 19 of the Notice I am told (pretty clearly I now believe) that, if my separation arrangement is not already subject to an SRF, I cannot reimpose SRF.

So, maybe the IRS is saying that we cannot in 2007 modify a bad good reason definition (assuming no other terms impose an SRF) to make it a good good reason definition and thereby change a full-fledged deferral to a short-term deferral, but we can modify the bad good reason definition to qualify for the 2-year/2-times exclusion.

I think you're right, but to clear up the confusion, the IRS considers a short term deferral to be an exception from the definition of deferred compensation and the 2-year/2-times to be an exclusion. The former is never deferred compensation, the latter would be but for the exclusion. That explains alot. On p. 20, they state that the payment of deferred compensation can be modified to be made only upon an involuntary separation from service, thus excluding it from the definition of deferred compensation (putting it under the 2-year/2-times rule). The IRS has already conceded that the amount is deferred compensation and so the ST deferral rule cannot apply. So it seems clear that such actions cannot cause the amount to be subject to an SRF so that the ST deferral rule applies, but can be excluded for purposes of the 2-year/2-times rule. You must be genius.

[Guest jhall]

If the agreement was in existence before January 1, 2005, and has not been materially modified since, if there is a "bad" good reason definition and thus no SRF, can't the amount be considered accrued and vested before the effective date of 409A and therefore grandfathered?

Chaz,

You raise an interesting and important question. Unfortunately, my understanding / assumption dating back to the early days of 409A and the grandfather provisions was that most employment agreements and severance agreements probably wouldn't qualify for the grandfather, at least not completely. I seem to recall some early discussions that in cases where there is severance to be paid based on salary at time of termination then the amounts of severance attributable to increased salary after 2004 would probably not be considered "earned and vested" and thus outside of the grandfather. Seems with the whole severance package subject to increases / changes from what was locked in prior to 2005, maybe there is an argument that all amounts are outside the grandfather. At any rate, my assumption has generally been that most pre-2005 agreements that have not been modified likely still need to be addressed for 409A.

I would be most grateful if somebody would tell me I'm completely wrong though.

[Guest bergs]

How, exactly, do you draft a document to satisfy the good reason safe harbor?

Do you have to use the exact language in the regs (e.g., "material dimunition in the service provider's base compensation")? Or is it enough to use a different definition that you're convinced fits into the safe harbor (e.g., "50% or more reduction in base pay")?

Any help is appreciated.