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:
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.