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Your First Deferred Compensation Agreement

By Cody Yorke

When negotiating an executive employment agreement, you have to consider not only the compensation but also the tax consequences and issues that may arise because of when or how you are compensated. To fully understand and avoid any potential pitfalls, you should ensure your compensation agreement complies with the requirements of section 409A of the Internal Revenue Code, a law that addresses taxation and regulation of deferred compensation arrangements.

What Is Deferred Compensation?

Deferred compensation is that portion of your employment compensation that is earned in one year, but not payable until a later date. Deferred compensation is broadly defined and includes long-term deferred compensation such as a deferred portion of the employee's incentive compensation, an annual bonus paid in the following year under a bonus plan, a special payment upon the happening of a certain event - such as a change in control - and even an entitlement to severance in an employment agreement or severance plan.

But if the employer retains an unencumbered right to deny or reduce the payment (like a completely discretionary bonus), it would not qualify as deferred compensation.

What Happens to Your Deferred Compensation When You Leave Your Job?

For the employer, deferred compensation is a means to attract and retain talented people, especially key employees. Many deferral plans allow for a forfeiture of the compensation if the employee leaves voluntarily or even if they are terminated without cause. Many employees wrongfully assume that their deferred compensation will be paid no matter what-- if and when they leave and are unprepared for the forfeiture of what they consider to be forced savings and deferred cash. This is often an unwanted surprise. Understanding your deferred compensation plan from with the help of sophisticated employment counsel is worth the time and the investment.

Each deferred compensation plan or agreement generally has specified treatment for the termination of employment in various scenarios, including by the employer with and without cause, by the employee voluntarily and for good reason, in the case of death, disability, or retirement, and a change in control of the company. It is important to understand how your deferred compensation will be treated upon your departure not only when you leave a job, but when you first negotiate the terms of your employment, as this can be the only opportunity to negotiate favorable treatment of your deferred compensation in certain types of terminations.

Tax Implication of Deferred Compensation

The Internal Revenue Code, Section 409A, provides a complex set of regulations regarding the tax treatment of deferred compensation. If a deferred compensation payment is not exempt from 409A or doesn't comply with its requirements the full scope of the payments (including both paid and unpaid compensation under the agreement) can become immediately taxable, and the IRS will levy a 20 percent penalty and interest charges on the tax-deferred portions.

These penalties and interest charges are imposed on the employee rather than the employer. For this reason, employees need to make sure their deferred compensation agreements are drafted to protect them from this possibility.

How to Comply With 409A and Avoid Penalties and Inconvenience? Consult an Experienced Employment Attorney familiar with Executive Compensation

Poorly drafted or inadequately considered deferred compensation agreements can result in claims, penalties, IRS audits and significant financial and tax consequences. A well-crafted agreement, on the other hand, can provide certainty and protect the employee from the risk of large tax repercussions. Because 409A can be triggered both by how a deferred compensation agreement is drafted and by how payments are made, it is critical to consult an attorney at both the outset of your employment and when payments are made upon the termination of your employment.

The lawyers in Outten & Golden's Executives & Professionals Practice Group are experienced in all aspects of executive employment and compensation. Although we are not tax attorneys, we understand the tax implications of deferred compensation and can review and negotiate employment and deferred compensation agreements to protect your compensation and help avoid unnecessary pitfalls.