How to Avoid Personal Tax Woes

A collection of gotcha’s, pitfalls, red flags and respectful reminders to help keep executives out of trouble with the IRS over their compensation.
Christine Osvald-MruzSeptember 9, 2013

Executive compensation can be fraught with peril, especially with respect to taxation. A number of treacherous federal tax provisions can create “gotcha” scenarios. Unexpected penalties, additional taxes or costly corrections can ensue from a missed deadline or a deficient agreement. Whether this is a reminder or alarming news, staying alert to the following issues can help avoid pain and suffering:

Deferred Compensation
One of the biggest compensation pitfalls is Section 409A of the federal tax code. You have to worry about 409A whenever a right to compensation is created in one year that is (or could be) payable in a later year. This can apply to severance arrangements, bonuses, equity compensation, reimbursements and other types of remuneration that you normally might not think of as deferred compensation. With the employee subject to a tax penalty of 20 percent of the deferred amount that’s in violation, compliance with 409A demands attention.

On a basic level, Section 409A requires that you specify a time and form of payment. Arrangements can be structured either to comply with 409A or to be exempt by meeting special exemption rules. The rules are not “flexible.” They are particularly rigid when it comes to changing the time or form of payment of deferred amounts set up to comply with (rather than be exempt from) 409A. This inflexibility makes it preferable in many cases to structure payments as exempt from 409A.

Potential problem areas related to executives’ deferred compensation include:

Stock options: Discounted stock options usually violate 409A. Under normal circumstances, a stock option must have an exercise price that is no less than fair market value on the date of grant. For publicly traded companies, determining fair market value is usually simple. One approach for private companies is to obtain an independent valuation. Another (for start-ups less than 10 years old) is to have a qualified person at the company perform the valuation. Unless a material change occurs, you normally can rely on an independent valuation for 12 months. Determining whether a change is material can be a challenge. Timing issues arise as well: If a company issues options just before signing a term sheet to sell the company, a higher valuation in the deal can lead to questions about the option exercise price.

It also is important to follow effective grant practices. Maintaining proper board practices to document option grants can avoid questions about the validity and grant dates of options later on.

Bonuses: If it is feasible to pay annual bonuses no later than March 15 of the following year, you can take advantage of the “short term deferral” exception to Section 409A. If a bonus is truly discretionary, it also is exempt from 409A. Otherwise, you need to be mindful of structuring the timing of the bonus so that it complies with 409A.

Severance contingent on a release:  The timing of severance payments often can become an issue. If an agreement provides simply for severance to be paid (or begin) on delivery of a release, it can run afoul of Section 409A. Establishing definitive timing for the delivery and effectiveness of the release and for the severance payments can fix this.

Startup-company woes: Early-stage companies often face cash shortages that cause them to indefinitely defer payments to employees. While the goal is to pay the employee as soon as the company has enough cash, that kind of promise usually will not work under Section 409A. One approach (under a 409A exemption) is to make the payment truly contingent on continued service and/or achievement of a target related to the business, and then require payment within a short period after the right to payment vests. Another approach is to pick a fixed time or fixed schedule for the payment (far enough in the future that the company is likely to be able to pay by then).

Promissory notes: Just because an agreement says it’s a “promissory note” does not mean it is outside of Section 409A’s reach. Payments of compensation are still subject to 409A.

Subsequent changes: Whenever you amend an existing agreement (even if you amend and restate the entire thing), use caution if changing the time and form of deferred compensation payments. Such changes are usually prohibited or severely constrained by 409A.

Six-month delay for public-company executives: Public-company agreements deferring compensation until a key employee’s separation from service must provide for payments to be delayed for 6 months after separation. It is possible to structure agreements so that most, if not all, severance still is paid within the first six months.

Section 457A and Deferred Compensation
While Section 409A places rigid barriers around deferred compensation, Section 457A of the tax code largely prohibits it. Section 457A applies to deferred compensation paid to U.S. taxpayers by foreign entities that are not subject to income tax (either in the United States or the country in which they were formed). Under 457A, compensation must generally be paid by no later than the end of the year following the year in which the right to the payment vested. If it is not paid within that period, it still will be taxed as if it had been paid. If the amount cannot be determined at the time the right to the payment vests, it will not be taxed until the amount can be determined, but a 20% penalty tax plus interest will apply.

Restricted Stock and Section 83(b)
Employees who receive unvested restricted stock have 30 days from the grant date to file an 83(b) election with the IRS. This election allows the employee to be taxed currently (and the company to take a current deduction) on the excess (if any) of the fair market value of the stock over the price the employee paid for the stock (if any). Without the election, the stock would be taxed as ordinary income as and when it vests, based on the then-current value of the stock.

By making the election, the employee’s basis and holding period for the stock is fixed at the time of grant, thereby allowing all of the appreciation to be taxed as capital gains when the shares are sold (assuming they have vested). Although the employee cannot get the tax back if the stock is forfeited, many employees make the 83(b) election when they expect the stock’s value to rise significantly (and take the risk of the downside if vesting does not occur). The catch is that there is no second chance once the 30-day deadline expires. This is a reminder to plan in advance for restricted stock grants and alert recipients to the short deadline.

Change in Control Payments and Section 280G
Big payments and significant benefits to an executive relating to a change in control (or a termination upon a change in control) can cause unexpected tax headaches. If payments and benefits that are contingent upon a change in control equal or exceed three times the executive’s average base pay, then all amounts in excess of the executive’s base pay are non-deductible by the company under Section 280G of the tax code. The excess amount also would be subject to a 20% penalty tax on the executive under Section 4999 of the tax code.

Private companies, but not public ones, often can avoid the penalties by having shareholders approve the excess “parachute” payments. Agreements can provide for tax gross-ups (expensive and currently out of favor), cutbacks or a “modified cutback” that allows the executive to get the better of the after-tax amount or the amount reduced to just below the amount that triggers the parachute tax.

Post-Termination Health-care Coverage
While it is common to promise executives ongoing health benefits as part of a severance agreement, caution is required. If your health plan is self-insured, promising post-termination benefits to highly compensated employees and not all employees can run afoul of tax rules. This can result in the executive being taxed on claims paid under the plan.

Under the Affordable Care Act, companies with fully insured health plans also can incur significant tax penalties by providing health-care benefits that discriminate in favor of highly compensated individuals. For fully insured plans, the company (rather than the employee) bears the tax penalties. One strategy is to provide executives with extra cash severance rather than providing post-termination health care benefits. Another strategy (for fully insured plans) is to state that the benefit applies only if it can be provided without penalty to the company.

Equity Incentive Plan Limits
Companies can run into trouble if they exceed the share limits of an equity incentive plan. When granting stock options, for example, you need to make sure there are enough remaining shares reserved under the plan to make the grant. If the plan contains limits on the number of shares that can be issued to an individual per year, this is another limit to check. When stock prices drop, companies may be especially vulnerable to exceeding limits if they make unusually large grants of options to executives.

For a number of these laws, the negative tax impact is on the employee. The company has an interest too, though. First, the whole point of compensation and incentives is, obviously, to compensate and incentivize employees. When there are unintended negative tax consequences for the employee, nobody is happy. Second, the company has to report and withhold correctly, and can face penalties for purposely failing to do so.

Mistakes often can be fixed, but awareness and proactive steps can avoid much torment and expense.

Christine Osvald-Mruz is a partner at the law firm Lowenstein Sandler LLP. She can be reached at [email protected] or 973-597-2440.

Photo credit: Creative Commons, Flickr member Ken Teegardin