We have been thinking and talking about Section 409A for more than 8 years now, but most of that discussion has been hypothetical. We have pursued compliance with Section 409A, but have been left to wonder: What would actually happen if an arrangement violated Section 409A? Is the IRS monitoring compliance or enforcing these requirements?

Well now we have some answers.

A federal court recently issued a ruling (here) dealing with the consequences under Section 409A of a discounted stock option arrangement. In addition to providing some specific legal analysis on Section 409A issues, the court’s decision provides some insights into how a case like this might arise.

Background. The case involves a founder and senior executive of a technology company (Marvell Semiconductor) who was granted stock options in 2003. In the wake of the various stock option backdating scandals, the company reviewed its option program and repriced the 2003 option grant. As a result, the executive paid over $5,000,000 in additional exercise price, presumably reflecting that the options had been substantially discounted when awarded.

The IRS Takes Notice. Disclosures regarding this repricing must have caught the IRS’s attention. In 2010, it issued the executive a notice of deficiency to the executive assessing additional taxes and penalties under Section 409A in excess of $3,000,000. The executive paid the assessed amounts and then sued to obtain a refund, arguing that the option arrangement was not governed by Section 409A.

The Court’s Analysis. The court made several important rulings regarding the impact of Section 409A for      Continue Reading...

A year-end deadline for correcting certain impermissible payment language in employment, severance, or similar agreements is fast approaching.

As background, Code Section 409A - which governs most arrangements providing for future payments of taxable compensation - generally requires that deferred amounts be paid at fixed or identifiable times (e.g., termination of employment or a specified date) and that the covered individual (e.g., employee) not have the right to designate the calendar year in which payment will be made. These rules apply to most severance-pay and similar arrangements that provide for payments in the event of a specified loss of employment (e.g., a termination without cause).

It is common for severance-pay and similar arrangements to condition an employee's right to payment on the employee providing a release of claims. But this can create an issue under Section 409A, depending on how the payment language is written. The IRS takes the position that the payment language must not provide any opportunity for the employee to control or manipulate the calendar year in which payment will be made.

As an example, assume an agreement provides for a right to payment at any time within 90 days after termination of employment, once the employee has delivered a release of claims. If the employee terminates employment on November 1, the employee can effectively choose which calendar year in which to receive payment (the year of termination or the next year) by deciding when to deliver the release. In comparison, if the agreement says payment will be made on the 90th day      Continue Reading...