The 409A Deferred Compensation Trap
Crestline Software, a private company, grants its CEO a supplemental executive retirement plan (SERP) that provides a lump-sum payment upon separation from service. The SERP document defines separation from service as "termination of employment" and does not specify a six-month delay for specified employees. The CEO also has a severance agreement that provides a lump-sum payment upon a change in control. In year one, the CEO's SERP account is credited with $500,000. In year two, the CEO's employment is terminated and the company pays the SERP benefit within 30 days. The CEO is a specified employee. The company also fails to include the SERP benefit in the CEO's W-2 wages.
1. Analyze the 409A compliance failures in the SERP and the consequences to the CEO and the company.
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The SERP has several section 409A compliance failures.
Six-month delay for specified employees. Under Treas. Reg. section 1.409A-3(i)(2), a payment to a specified employee upon separation from service must be delayed for six months (or until death, if earlier). The CEO is a specified employee, and the SERP does not provide for the delay. Paying within 30 days of termination violates this rule.
Definition of separation from service. The SERP defines separation from service as "termination of employment," which does not satisfy the 409A definition. A separation from service occurs when the employee dies, retires, or otherwise has a termination of employment that reduces the level of bona fide services performed to 20% or less of the average level of services performed over the immediately preceding 36-month period. The document's definition is ambiguous and may not comply.
Consequences to the CEO. The CEO must include the vested SERP benefit in gross income in the year of vesting (not the year of payment), plus an additional 20% tax under IRC 409A(a)(1)(B), plus interest at the underpayment rate plus 1%. The CEO's W-2 should have included the $500,000 in year one (when vested), not year two.
Consequences to the company. The company has withholding and reporting obligations. Failure to include the amount in W-2 wages may result in penalties under IRC 6721 and 6722. The company should also consider correcting the failure under the IRS correction program for 409A operational errors, which may reduce the 20% additional tax if corrected in the same year.
2. Evaluate the change in control severance payment under 409A and section 280G.
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The change in control severance payment implicates both section 409A and section 280G.
Section 409A. A change in control payment is a permissible payment event only if the change in control constitutes a change in control event under Treas. Reg. section 1.409A-3(i)(5). The regulation requires a change in the ownership of the corporation, a change in effective control, or a change in the ownership of a substantial portion of the assets. The severance agreement must define the event in a way that satisfies the regulation. If the agreement uses a generic "change in control" definition that is broader than the regulation, the payment may be subject to 409A.
Section 280G. A change in control payment to a disqualified individual (which includes the CEO) that equals or exceeds three times the individual's base amount is an excess parachute payment. The excess is subject to a 20% excise tax on the individual and is nondeductible to the corporation. The base amount is the average annual compensation over the five years preceding the change in control. The company should calculate the base amount and determine whether the payment exceeds the threshold. If it does, the company may consider a shareholder approval procedure under section 280G(b)(5) to avoid the excise tax, but that requires disclosure to and approval by shareholders.
The company should also consider whether the SERP and severance payments are aggregated for 280G purposes.