Is this a short term deferral?

[jpod]

Plan provides for payment to participants of a portion of the sales proceeds if (and only if) there is a change in control. (It is a 409A-compliant definition of change in control, if that's relevant). Payment is to be made at the same time as the sales proceeds are paid to the selling owners (if a stock sale) or to the corporation (if an asset sale). If part of the sales proceeds are in future installments or escrowed or subject to earn-out contingencies, participants get paid their respective shares only as those deferred or contingent payments are received, but in no event will participants have any right to a share of payments received later than 3 years after the change in control.

If this arrangement is a ST Deferral not subject to 409A, the corporation and one or more participants can agree to cancel their participation in exchange for a lump sum payment now (there is no change in control in sight). If the arrangement is subject to 409A, this would be a prohibited acceleration. (Can't use the voluntary termination exception here.)

[jpod]

Bumping this up. Any thoughts?

[401 Chaos]

Jpod,

This is top of the head without any research but I believe the provisions you describe likely would not qualify for the short term deferral exemption and thus would be subject to 409A.

If I understand correctly, you have an arrangement whereby payments triggered by a Change in Control are made at the same time sale proceeds are paid to the stockholders / company, including provisions that contemplate that some of these amounts may be deferred following the Change in Control to accommodate installment payments as well as earn-outs, escrows, or other contingent payments.

If we assume one possibility are true installment payments that are essentially vested / earned at the time of a Change in Control but merely deferred to be paid out later over some to be agreed upon schedule or period, I think the mere possibility that such amounts might be deferred beyond 2.5 months following the end of the year in which Change in Control occurs probably takes the whole arrangement out of the running for short-term deferral exemption.

On the other hand, if the arrangement you have contemplates that any delayed payment amounts will truly be contingent amounts that may or may not ever be paid out depending upon whether the earn-out targets are hit, the escrowed contingencies occur, etc., then I think you have a better argument that those amounts remain subject to a substantial risk of forfeiture and may not actually vest (and thus the short-term deferral clock may not start running) unless and until you know for sure whether the amounts are to be paid. Unfortunately, however, I do not know you have a clear, slam-dunk argument even in that case. I think that may depend to some degree on how substantial the risk of complete nonpayment or "forfeiture" is and I think that will necessarily depend on the overall facts and circumstances involved.

In my experience, it seems most escrows and earn-outs are designed so that it is substantially likely (albeit not certain) that the stockholders / company will receive at least a portion of the contingent amounts. If that is generally the case, I am not sure what you do in analyzing now where there is no specific change in control / transaction in sight and so no specific contingency provisions to analyze. My fear would be that the IRS could always call into question whether there was a substantial enough risk of forfeiture of the amounts to qualify for the exemption.

FWIW, it seems to me the special rule for certain delayed payments in connection with a Change in Control included in 1.409A-3(i)(5)(iv) do not help you with the short-term deferral analysis as I interpret those to basically say tying the contingent payments to the same time payments are made to stockholders generally, etc. really only helps ensure that you have 409A-compliant payments and does nothing to exempt those payments.

Let me ask another question. Does or did the company generally treat the arrangement at issue here as one subject to 409A before this coming up. You note there is a 409A-compliant definition and they seem to have designed (either intentionally or not) to comply with the special rule under 1.409A-3(i)(5)(iv), etc. Maybe there are other clues suggesting they thought they were setting up an arrangement subject to 409A with payments tied to acceptable Change in Control triggers. If that is the case, seems that might also be facts the IRS might use to conclude that the company did not regard or intend the original arrangement to provide for all payments to be within short-term deferral period following a Change in Control. (Not saying that is the case or that the IRS would look to that in analyzing but I suppose that is possible.)

Again all of this is without benefit of any research. Would love for somebody to respond with support for finding all of this to be within the short-term deferral exemption.

[jpod]

That's pretty darn good for "off the top of the head." Your analysis is basically the same as mine.

I don't know, but I am pretty certain that nobody was interested in latching on to the S-T Deferral exemption. I am pretty certain that the goal was to make sure that the phantom participants got paid only when the shareholders/company got paid, while at the same time structuring this to comply with 409A. That would explain the 3-year time limitation, although under 409A they could have gone out as far as 5 years.

Assuming there is no S-T deferral, my other thought here is that perhaps we don't even have a "legally binding right," which is a pre-condition for entering into the realm of 409A in the first place. Specifically, it is within the total control of the Company/shareholders to sell the Company at all, ever, and if they do decide to sell the Company, in view of the the 3-year time limitation it is within the total control of the Company/shareholders to structure a deal whereby there is no payment whatsoever during the first three years and therefore the phantom participants would get zero. Too much of a stretch?

The problem is that now there is a desire to dump this plan, but it can't be dumped unless the participants agree to that, and obviously they won't agree to that unless we pay them something to agree to dump it, and if we pay them something in exchange for their agreement to dump it that would be an impermissible acceleration (I think) if we have a plan subject to 409A. The voluntary termination exception is not viable here for a couple of reasons which I'd rather not get into.

[401 Chaos]

Jpod,

I like your thinking but I am concerned that framing the arrangement as not creating a "legally binding right" because a deal is within the Board's control would not fly. To be sure, the right to payment here is conditional or subject to a contingency that is presumably entirely(or largely) within the control of the Board. I think 1.409A-1(b)(1) generally provides that the appropriate test for whether a legally binding right exists is not whether the right is subject to a contingency but whether a payment promised to one party may be unilaterally reduced or eliminated by the other party. (See Ch. II.B. of the Section 409A Handbook.) Based on the rest of your response, I take it that is not the case and if the Company went forward with a Change in Control that came within the definition in the agreement and didn't pay the participant, the participant could clearly sue.

I'm not sure I've ever seen any formal (or even informal) guidance on change in control bonuses and whether a legally binding right exists with those but I do take your point that such an event is clearly more within the discretion and control of the Board than some other triggers. That still seems different to me though than an arrangement which basically says we will pay you a Change in Control amount unless the Board, in its sole discretion, decides we no longer desire to provide you such a bonus in the event of a Change in Control. I am concerned the Service would say the Board's ability to indirectly eliminate or never pay the amounts by simply avoiding a transaction is not the same type of clear, unilateral right of a service recipient to eliminate payments they had in mind as an exception to creation of a legally binding right.

I share your pain with respect to the potential issues that the anti-substitution. non-acceleration and subsequent deferral rules all potentially place on the ability to amend existing agreements which have not been triggered and are not about to be triggered but the parties desire to amend or change for legitimate business reasons that have little if anything to do with manipulating income deferrals. I fear this is an area that may trip up many going forward who have no idea amending agreements create 409A problems.

[jpod]

401(a) Chaos. Thanks for your thoughts. Let me know if you agree with this line of thinking.

Suppose the Company and the plan participants wish to be conservative and proceed on the assumption that there is a real 409A problem with dumping this plan. Let's then suppose that they agree to dump the plan anyway and each participant is paid $X, and it will be reported as a 409A violation. It seems to me that the only adverse consequence of this is that the participants will have to pay the extra 20% tax on the $X, and there is no "interest" charge because the participants were never vested. So, if the Company grosses them up for the 20% additional tax assuming a 40% marginal tax rate (Fed. income tax, Medicare and State income tax), the additional cost to the Company is 33-1/3% of $X. (There is no additional 20% on the gross-up.)

[401 Chaos]

Jpod,

That all seems plausible to me but to be honest I've never really tried to work through an admitted violation (or at least not of unvested amounts) so not sure I can really weigh in effectively on that. My sense is the proposed regulations seem to give pretty broad powers to fix or correct arrangements that are "unvested." If these truly are unvested rights (and not merely subject to a contingency that isn't likely in the foreseeable future) perhaps you have some broader basis for arguing the whole arrangement might be "revised" or changed somehow under the proposed regulations. I know Rosina Barker and Kevin O'Brien have some helpful articles on corrections, including corrections outside of the formal IRS corrections programs that may be helpful if you have not previously had a chance to review those.

[jpod]

We don't wish to correct anything. We wish to get rid of the plan. If we were to take steps per the correction procedures to make this clearly a st deferral arrangement, and then immediately terminate the plan, I don't see how that could possibly pass the smell test.

[401 Chaos]

Understood. I was just wondering if there might be anything in the corrections-related discussion that might be helpful as far as correcting an admitted violation or maybe possibly terminating altogether with minimal penalties.