409A Final Regulations - Focus on Employment Agreements

Employment agreements have long been a part of executive compensation. In fact, it has historically been a rare executive, who was hired without a long, detailed, written agreement laying out the terms of his employment - what his initial base pay and incentive opportunities would be; what his equity compensation would be; what other forms of benefits and compensation he would receive; what perquisites he would be eligible for; and how much of that he would receive in the event of his termination, whether it be for cause, on account of a change-in-control, or for some other reason. Many of the provisions in these agreements relate to amounts of "compensation" that might be earned in one year, but not necessarily payable until some future point in time. Generally, to the extent that such compensation is not in qualified plans, it is deferred compensation, which is potentially subject to 409A.

To understand what that means, let's back up for a moment and look at the basic requirements of 409A. For "any agreement, method, program, or other arrangement that applies to one person or individual", Code Section 409A requires all of the following (not an exhaustive list):

*        The agreement must be in writing;

*        The employee must elect, in the year prior to the year during which the compensation is earned, both the timing of the distribution of compensation, and the form of such distribution;

*        Distributions must be on account of separation from service, disability, death, unforeseeable emergency, change-in-control, or at a specified time (or schedule);

*        The time of distribution may not be accelerated except to the extent that a new time (or schedule) is elected at least 12 months prior to the scheduled date of distribution, and not to occur less than 5 years after the previously elected time; and

*        The form of distribution may not be changed except to the extent that a new form of distribution is elected at least 12 months prior to the scheduled date of distribution, and not to take effect less than 5 years after the previously scheduled time of distribution.

So, what's the big deal with employment agreements? They are virtually always written, and signed by both parties (the executive and the company) before any compensation is earned. The problem is that an employment agreement is a contract, between an employer and an employee. And, such employment agreements frequently give executives specific rights with regard to their benefits and compensation. And, sometimes those rights do not satisfy the requirements of 409A.

An example may help here. Executive E was hired by Company C on January 1, 2003, pursuant to a lengthy employment agreement. As part of that agreement, E has the right to defer any portion of his bonus to any future year. And, since the bonus earned in Year X is not actually payable until March of Year X+1, the employment agreement says that E must make his election with regard to deferral of his bonus at any time during Year X. But, this is in violation of the regulations under 409A. The regulations specify that the deferral election be made in the year before the bonus was earned, or, in some very specific situations, not later than the later of six months after the beginning of the year, or the date on which the amount of the bonus is reasonably certain.

What should the company and the executive do? Well, the employment agreement needs to be amended. But, this cannot be done unilaterally. The agreement is a contract between the company and the executive. So, both must agree to any changes. Does this mean that the entire contract is subject to renegotiation? Perhaps, it does.

There is one more key requirement of 409A that we left out of the earlier discussion in this article. If, as of the date of the employee's separation from service, the employee is a "key employee" (see Code Section 416(i)) of the company (generally, one of the top 50 highest paid officers for the preceding calendar year) and any stock of the company is publicly traded on an established securities market, then, in general, any (409A-covered) payment intended upon separation from service to the employee must be delayed by six months (again, this may be in violation of the employment agreement), and the method for determining key employees must be written into the plan (recall that each agreement between the company and each employee theoretically constitutes a separate plan).

Most companies sponsor far more plans of deferred compensation than they are aware of. Many are imbedded in other documents, such as employment agreements. All must be in writing and compliant with 409A both in their written form, and in their operation by the end of 2007. This will be a daunting task for many companies. To the extent that they have not, we would strongly recommend that these companies begin inventorying all of these plans now.