Correction of Errors before Year End Could Avoid Costly 409A Penalties
Sometimes overlooked is the fact that many employment, severance and change-of-control agreements are subject to U.S. Internal Revenue Code Section 409A (applicable to deferred compensation). For non-U.S. companies and their U.S. subsidiaries, it is important to remember that U.S. citizens and U.S. residents are taxed on world-wide income. As a result, U.S. citizens who are employed by, or serve as directors of, non-U.S. entities can incur significant tax penalties (regardless of where they live) if compensatory arrangements violate Section 409A. If compensation plans and agreements have not been reviewed previously, doing so sooner rather than later could avoid significant additional taxes for the executive.
Common provisions that make an arrangement subject to Section 409A include the requirement to pay the executive severance upon termination, or the ability of the executive to quit and be entitled to separation pay upon a change-of-control. Such provisions may be acceptable, if certain Section 409A requirements also are set forth in the document (such as a provision requiring a six month delay prior to making such a payment). Section 409A requires documentary compliance as well as operational compliance, and a failure can result in the Section 409A 20% “penalty” tax. In some cases, the document failure can be corrected without penalty if corrected prior to the year in which the right to payment becomes vested. For example, if an agreement that does not comply with Section 409A gives an executive the right to quit following a change-of-control and to receive separation pay which is subject to Section 409A, the right to such payment does not become vested until the change-of-control occurs. If the document failure is found now, it can be corrected on or before December 31, 2015, and if no change-of-control occurs before December 31, 2015, the correction will not entail a penalty or additional tax. This correction relies on the 409A “income inclusion regulations” that assess penalty taxes based on vested amounts on a year-by-year basis.
Also, available under limited circumstances are corrections under the IRS’ formal 409A documentary and operational correction programs. These programs also generally reward early detection of 409A issues, and may result in avoiding or minimizing 409A penalty taxes.
If compensation arrangements have not been reviewed for Section 409A compliance, we recommend doing so now, especially with respect to arrangements that will or may become vested during 2016.