Editor: What should legal counsel be doing now to ensure that employers will be in full and timely compliance with Code §409A?

Harmon: This is largely a matter of identifying that full and timely compliance is an immediate issue.
Counsel should be prompt in making clients aware of the requirements of
the statute - an audit of all employment, plan and benefit documents is
appropriate in these circumstances to assess which documents require
changes as the Code §409A deadline approaches.

Bruder: It is important that counsel for employers carefully review all the
documents we have talked about to identify areas in which deferred
compensation may occur. I cannot stress enough that once those
arrangements have been identified, it is imperative to get the
appropriate documentation in place as quickly as possible in order to
meet the end-of-year deadline. It is also essential to confirm that
good faith operational compliance has occurred over the last couple of
years with respect to those arrangements.

Editor: Under what circumstances will a gross-up be applicable or available in light of Code §409A?

Bruder: It is important to understand how this circumstance -
the payment of a gross-up - could lead to deferred compensation. In
general terms, what we are talking about is some taxable event that may
occur in the future, and the employer is agreeing to effectively pay
all or a portion of the income tax imposed on the executive in
connection with that event. The payment of that tax amount by the
employer is by definition compensation to the individual. And, because
it may not be paid until some point in the future, it is deferred
compensation. Gross-ups are, accordingly, one of those items that may
not look like deferred compensation but under the broad definition
enacted under Code §409A constitute the kind of trap that employers may
encounter if they do not proceed with care. The final Treasury
Regulations promulgated under Code §409A make clear that certain timing
rules apply to tax gross-up payments made by employers, and these
timing rules must be satisfied for the arrangement to avoid a violation
of Code §409A.

Harmon: Gross-ups are certainly a legitimate subject of
negotiation between the employer and the employee in an employment
contract or a severance arrangement. It is essential, however, for both
parties to understand the deferred compensation consequences of any
such contractual arrangement and to make sure the arrangement is in
full compliance with the statute.

Editor: What are some of the Code §409A issues that need to be addressed in employment agreements?

Bruder: Getting back to a point that we discussed earlier,
very often an employment agreement will include some provision that
calls for a payment of compensation at a future date or upon the
occurrence of some future event. Almost invariably such a provision is
going to be deferred compensation irrespective of what was contemplated
by the parties when the agreement was negotiated, and the effect of
Code §409A must be considered. If the provisions of the agreement are
not in compliance, all of the negative financial impacts we have
discussed come into play. In light of what is at stake in terms of
ordinary income tax, excise tax and interest, it is crucial that all
undertakings that might possibly be considered deferred compensation be
reviewed forthwith and, if not compliant, brought into line as soon as
possible and certainly by the end-of-the-year documentary compliance
date.

Another potential Code §409A issue has to do with employment
agreements which include compensation features that are equity-based.
Depending on how such provisions are structured, Code §409A may be
applicable. We have counseled our clients accordingly and recommend
that any equity-based incentive compensation arrangement reflected in an employment agreement be reviewed for Code §409A compliance.

Harmon: The immediate issues derive from the necessity to
structure an arrangement so as to reflect good faith compliance with
Code §409A and full documentary compliance by the end of the year. The
question of indemnification of the executive by the company is not
insignificant. In structuring these arrangements it is wise to consider
whether, and to what extent, the executive can look to the company for
a tax gross-up in the event a Code §409A penalty is imposed on a
particular arrangement.

Editor: How is termination of the employment relationship affected by Code § 409A?

Bruder: Code §409A specifically addresses a couple of
technical issues in connection with termination of employment. First,
in order for a permissible payment of deferred compensation to take
place, a trigger event must occur. One of those trigger events is a
separation from service. The provisions of Code §409A include a very
specific definition of separation from service. In general terms, an
individual whose employment is terminated won't have a problem meeting
that definition and therefore will be eligible to receive a permissible
payment of deferred compensation. However, very often - where a key
executive is involved or a contract of employment specifically so
provides - an executive will terminate his employment as an employee
but subsequently will be retained as a consultant to the company. The
provisions of Code §409A and specifically the final regulations address
this circumstance and provide specific guidelines under which a former
employee can provide consulting services to the company. If the
executive provides significant consulting services, for example, he
will not been deemed to have had a separation from service. In that
situation the payment of deferred compensation is impermissible.

Another provision of the statute requires that if the executive is a
specified employee and entitled to a payment on termination of
employment, there must be a six-month delay in the payment date. This
is intended to ensure that the capital of the company is available to
meet certain contingencies - the Enron type of situation, where the
executives left with all the cash and the company was rendered
effectively insolvent, comes to mind - and in structuring an employment
agreement both parties should be aware of the fact that immediate
payment on termination may not be available.

Let me also mention that Congress, in its wisdom, provided a safe
harbor with respect to certain severance arrangements. In general
terms, as long as the individual who is voluntarily leaving his or her
employment is not receiving a payment that is more than two times his
or her base salary, and provided that amount is going to be paid out
within 24 months of the date of termination, the provisions of §409A do
not need to be satisfied. That is, if the deferred compensation
arrangement is structured within the safe harbor, it need not meet the
requirements of the statute.

Harmon: Structuring an employment agreement with specific
attention to the post-termination compensation structure requires
careful accounting to ensure §409 compliance. Parties may negotiate
§409A indemnification by the company in certain circumstances.
Allocation of risk regarding §409A compliance is an issue that should
be addressed in the negotiation of a comprehensive employment agreement.

Editor: How has the enactment of § 409A impacted the current trends in structuring executive compensation arrangements?

Harmon: The implementation of Code §409A has had an enormous
impact on the education of the parties to employment and severance
agreements, or at least it has had that effect on the lawyers who serve
those parties. The statute compels us, as practitioners in this area,
to ensure that our clients understand the need for compliance and the
risks associated with a failure to do so.

Bruder: One of the areas where the statute has had
considerable impact on structuring executive compensation arrangements
is change of control situations. In general terms, Code §409A does not
allow for any alteration in the timing of a payment of deferred
compensation to an individual. There can be neither an acceleration of
payment nor a deferral of payment other than within the original
structure of the arrangement. There are, however, certain exceptions.
If there is a change of control of the company - if it is taken over by
some other company or sells a significant asset - then, provided the
definition of change of control of Code §409A is met, that triggering
event enables the executive to receive a deferred compensation payment
without penalty. Even if the arrangement provides for payment many
years in the future, a change of control that meets the definition
results in permissible deferred compensation. Under certain
circumstances, even a partial sale of the company may trigger a
permissible payment of deferred compensation. Accordingly, it is
important for counsel to structure these arrangements with a great deal
of care. If it is intended that the executive be entitled to the
payment of deferred compensation on a partial sale of the company, the
agreement should so specify in compliance with Code §409A. And if the
intention is to pay the executive only in the event of a change of
control, it is important for the agreement to define change of control
with direct reference to Code §409A.

Editor: Is there anything that you would like to add?

Bruder: In recent years deferred compensation has become a
far more important element in executive compensation than it was in the
past. In our discussion we have been focused on Code §409A - which, of
course, has been enacted in direct response to the need to bring some
regulatory structure to the deferred compensation area - but the tax
implications of any compensation arrangement, deferred or otherwise,
are important. When structuring these compensation arrangements,
deferred or otherwise, counsel must take into account a whole range of
taxation issues. If, however, deferred compensation is a
feature of the arrangement, Code §409A must be paramount in his mind.
That is because the negative financial consequences are so onerous that
a failure to comply could have immense consequences for both the
executive and the company. To be sure, it is the executive rather than
the company who bears the brunt of this statute, but an angry CEO who
has performed well on behalf of the company and its shareholders, only
to see the benefits of that effort evaporate in penalties, taxes and
interest, is not necessarily going to provide the kind of leadership
the company expects. Counsel to the company has as much interest in
getting the Code §409A compliance aspect of the employment agreement
right as counsel to the executive. I would make the same assertion with
respect to such compensation arrangements as equity-based incentive
compensation, stock options and stock appreciation rights and the
variety of corporate perquisites that have come to the fore in recent
years. Whether governed by Code §409A or not, these arrangements
contribute to the well being of the company and its shareholders.
Conversely, if not properly structured, they can contribute to
extremely adverse outcomes for the company.