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Section
409A Compliance:
Bonus Arrangements and Deferring Performance-Based Compensation
(February
17, 2006)
Bonus Compensation and Section 409A
Deferring Performance-Based Compensation
Future Alerts
This alert, the fifth
in a series regarding Section 409A compliance and the proposed 409A
regulations, discusses the deferral election rules applicable to
performance-based compensation and Section 409A application and
considerations for bonus arrangements.
Bonus Compensation
and Section 409A
Generally, Section 409A applies any time an employee
performs services in one calendar year and receives the compensation for
those services in a future year (What
is Subject to 409A). Accordingly, Section 409A will apply to
bonuses that are paid in the year following the year in which the
services giving rise to the bonus are performed unless the “short-term
deferral” exception applies. The short-term deferral exception applies
as long as the compensation is payable within 2 ½ months following the
later of the calendar year or the employer’s fiscal year in which the
payment is no longer subject to a
substantial
risk of forfeiture. However, the bonus payment may be made after the
2 ½ month short-term deferral period without incurring a violation of
Section 409A if it is administratively or economically impracticable to
make the payment within the 2 ½ month period or if making the payment
within the 2 ½ month period would jeopardize the solvency of the
employer, the impracticability or insolvency was unforeseeable, and the
payment is made as a soon as reasonably practicable. Counsel should
always be consulted prior to delaying any payment, including a bonus, to
an employee without the employee’s consent, as the delay in payment will
likely violate the North Carolina Wage and Hour statute.
Here is an
example to illustrate these rules. If an employee earns a bonus to be
paid by March 15, 2007, based on services performed during 2005 and
2006, and the bonus is never subject to a substantial risk of
forfeiture, then the bonus is subject to Section 409A. If the same
bonus is payable only if the employee is employed on December 31, 2006
(a substantial risk of forfeiture), then the bonus is not subject to
Section 409A, because it will be paid within 2 ½ months after the year
in which the employee became vested in the bonus because of being
employed on December 31, 2006.
Bonus
programs that are subject to Section 409A must be in writing.
Except for bonuses that are totally discretionary, North Carolina Wage
and Hour Law also requires that bonus programs be in writing. In
addition, under IRS transitional rules, employers only have until
December 31, 2006 to document their unwritten bonus programs that are
subject to Section 409A. Because the Section 409A taxation
penalties are so harsh, employers would be well advised to document and
operate their bonus programs in compliance with Section 409A and
North Carolina state law. If the employer also maintains other
account balance deferred compensation plans, a violation of the Section
409A rules with respect to one bonus payment for the participant will
expose all of that participant’s other vested account balance deferred
compensation to Section 409A taxation. Click here
to view the Treasury Department and the
IRS proposed regulations regarding deferred compensation
agreements under Section 409A of the Internal Revenue Code.
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Deferring
Performance-Based Compensation
Generally
under the Section 409A rules, a participant must elect to defer
compensation by the end of the calendar year preceding the calendar year
during which the participant will perform the services giving rise to
the compensation. There is an exception to that rule for
performance-based compensation. A participant may elect to defer
performance-based compensation as late as six months prior to the end of
the performance period. Such an election can be made only if at the
time of the deferral election, the amount of compensation is not readily
ascertainable or the right to receive the promised amount of
compensation is not substantially certain.
To qualify
as performance-based compensation, the compensation must arise from the
participant’s satisfaction of pre-established criteria over a
performance period of at least 12 consecutive months. The
pre-established criteria can be based on either organizational or
individual performance criteria. The criteria must be established no
later than 90 days after the beginning of the performance period. If it
is substantially certain that the performance criteria will be met at
the time the criteria are established, then the compensation does not
qualify as performance-based compensation.
The
performance criteria may be subjective only if they relate to the
performance of the participant, a group that includes the participant,
or the participant’s business unit. The determination that the
subjective criteria have been met must not be made by the participant or
a family member of the participant. The determination also may not be
made by someone under the supervision of, or whose compensation is
controlled in any part by, the participant or a family member of the
participant.
Compensation can be considered performance-based even if the
compensation is based solely on the increase in the value of the service
recipient’s stock. To qualify as performance-based compensation,
however, the compensation must be based solely on an increase in the
value of the stock after the date of the grant or award (for example,
the stock right cannot have been granted with an exercise price of less
than the stock’s fair market value on the date of the grant), unless the
compensation is subject to a performance-based vesting condition.
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Future Alerts
The
final alert in this Section 409A series will cover equity compensation
and split dollar arrangements.
If you have any questions
regarding this alert or other Employee Benefits Law related issues, please
contact one of our Employee
Benefits attorneys.
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