We’ve made it to the final alert in our five-alert series intending to explore common pitfalls for closely-held businesses and their benefits and compensation arrangements. This alert (again, the last in the series of five) discusses some executive and deferred compensation basics (and may feature some compensation that you didn’t know was/may be deferred compensation).
If you missed or would like to revisit the first four alerts in our series, please see the links below.
Part 1: Health Insurance
Part 2: 401(k) Plans
Part 3: Administrative “Gotchas”
Part 4: Perks
When a company is small, emerging and/or closely-held, some things (including executive compensation) can be left more informal and/or subject to a fair amount of discretion and haphazard change given a variety of circumstances (including the health of the business). Seemingly innocuous arrangements or concessions can unexpectedly lead to very big tax problems. Here are a few examples:
- Pay Me Later. The organization is struggling and the CEO says: “I know I’m due wages this year (2018), but we’re a little tight on cash, so just pay me next year.” Seems reasonable, right? Well, it may be reasonable, BUT if the compensation is earned in year one (2018) and paid in year two or later (2019 or beyond), we’ve created deferred compensation.
- Unless the compensation is structured to meet an exemption from 409A, it must comply with those draconian rules (including having the arrangement set forth in writing specifying time and form of payment, among other things). Counsel versed in 409A should be consulted in this scenario so as to avoid unintended tax consequences.
- We’ll Formalize it Later. A group of siblings strike a “handshake deal” whereby they agree that each will receive certain compensation if/when they retire.
- Again, having informal, unwritten deferred compensation arrangements may violate Code Section 409A. Counsel needs to be involved to properly structure and document the arrangement to avoid immediate taxation and penalties on that future payable compensation.
- We’ll Fund it Now. The sibling deal noted above is properly documented (phew!) and now there’s concern about liquidity to fund the benefits if/when they become due. So, the siblings set up a trust and fund the deferred compensation arrangements. Seems smart, right?
- Well, unless the trust is set up as a "rabbi trust" (also called a grantor trust), the trust corpus will become taxable to the beneficiary immediately. A so-called “rabbi trust” is generally established as an irrevocable trust created for the benefit of the plan participants but with respect to which the assets remain subject to the claims of the employer's general creditors in the event of the employer's bankruptcy. Otherwise, the assets may only be used to pay benefits under the plan.
- Once a rabbi trust is funded, consider the litany of investment vehicles, including company owned life insurance (i.e., COLI).
- COLI is sometimes purchased by a company to help ensure that the company will have the cash to fulfill its promise to provide benefits. The employer is the owner and beneficiary of the policies and pays the premiums. The employer will pay benefits to the employee with funds obtained from borrowing against the cash value of the policies and from the proceeds received on the death of the employee.
- Split Dollar life arrangements are no longer popular but might be worth considering.
- 409A Doesn’t Apply to Us (That’s a Public Company Concern). Assuming 409A doesn't apply to an organization is a critical mistake.
- While the IRS hasn’t yet released promised guidance regarding partnerships or LLCs, most of the 409A rules (including the stock option rules) apply to such entities by analogy.
- While certain more draconian provisions (e.g., the 6-month delay in payments made on account of a separation from service) are limited to public companies, the law generally applies to private and public companies alike. When a company is or may be setting up deferred compensation (even in adopting a new executive employment agreement), 409A counsel should be engaged to ensure the arrangements do not unexpectedly result in unintended unfavorable tax treatment.
- Assuming a Separation/Severance Agreement Won’t Trigger Tax or Benefit Considerations. A few hallmark “gotchas” in separation/severance agreements include:
- Agreeing to keep an employee on benefit plans after their termination. This may or may not be permissible, depending on the circumstances.
- Including a release of claims without an outside time frame for executing the agreement (e.g., saying an individual has at least 21 days to execute the agreement but no expiration date is contained therein). Here, it’s important to consider possible 409A triggers.
- Delaying payments (either one or a series) into a second tax year without consideration of tax implications. Again, 409A may present cause for concern.
- Changing the time and form of payment of previously negotiated payments. While rehashing a previously struck deal may seem like a good deal (and may be preferred by the company and separating employee), 409A may cause issues with such an arrangement.
- Paying out Benefits/Severance on a Sham Separation or Failing to Pay When there is a Bona Fide Separation. Paying out amounts due based on a separation from service when there ISN’T a “separation from service” or not paying when there IS each can trigger major tax problems.
- Code Section 409A generally only allows for payment in certain limited circumstances, including a separation from service. Whether a separation from service has occurred under Section 409A’s definition may or may not be different from the company's practice on termination of employment. Counsel engagement may be necessary to help determine whether a separation from service has occurred.
- Consider the following:
- The organization has decided that Mom, now CEO, will “retire”, change her title to Executive Vice President and only come in 4 days a week instead of 5 (or 6 or 7) – under these facts, there is NO separation from service (or severance from employment which is the relevant term of art for 401(k) plan purposes), so payment from nonqualified deferred compensation arrangements (and 401(k) plans) cannot begin on those grounds.
- Alternatively, Mom CEO hasn’t come into the office but once a month for 3 years and doesn’t work remotely, but remains “available” for advisory/consulting services (which have never been nor are ever expected to be used) and still draws a salary. Here, if she performs no services and the expectation is that she will not perform any such services, she has incurred a separation from service. Thus, payments due upon a separation from service should be made (or commence, as applicable) despite her continued treatment as an “employee.” Note, whether the organization can continue to deduct her compensation as a reasonable business expense (and/or keep her enrolled in active employee benefits as an “employee”) is an entirely separate topic.
As we close our closely-held business benefits series, we hope you’ve learned something. While benefits and compensation are a necessary part of attracting, engaging, rewarding and retaining talent (both rank-and-file and management), properly implementing and managing these programs takes work. And being proactive in “cleaning up” any issues will almost certainly limit liability for future problems (and liability) on audit or in litigation.