Deferred Compensation Issues Relating to Changes in Control and Other Corporate Transactions

By Maureen J. Gorman, Daren F. Grotberg, Debra B. Hoffman, Herbert W. Krueger, Wayne R. Luepker, Anna M. O'Meara and Cecilia A. Roth

Last fall, Section 409A was added to the Internal Revenue Code of 1986, as amended (the "Code"). Section 409A sets forth certain rules that must be satisfied with respect to nonqualified deferred compensation plans in order to avoid significant penalties for the employees participating in such plans. Section 409A generally applies to compensation deferred on or after January 1, 2005. It also applies to compensation deferred prior to that date if the compensation was not earned and vested on or before December 31, 2004, or if the arrangement under which such compensation is payable was subject to certain material modifications after October 3, 2004.

Interim guidance under Section 409A was provided in Notice 2005-1 (the "Notice"), published on December 20, 2004 and modified on January 6, 2005. Proposed regulations under Section 409A were published on October 4, 2005 (the "Proposed Regulations"). This memorandum discusses the provisions of the Proposed Regulations as they relate to changes in control and other corporate transactions.

Deferred compensation is broadly defined for purposes of Section 409A. In addition to traditional deferred compensation, such as elective deferrals and supplemental retirement arrangements, it may include other arrangements not typically considered to be deferred compensation, such as certain stock option and other equity grants, severance and change in control arrangements, reimbursement of post-termination expenses and provision of in-kind benefits after termination of employment.

The statutory requirements apply to directors and certain independent contractors in addition to employees. For ease of reference, however, this memorandum will use the term "employee" to cover all persons subject to the new rules.

Note that, although the provisions of the Proposed Regulations relating to changes in control and corporate transactions have not been extended to partnerships, the preamble to the Proposed Regulations indicates that the IRS plans to issue regulations that will allow an acceleration of payments upon a change in control in the ownership of a partnership or a sale of a substantial portion of the assets of a partnership. The preamble provides that, pending that guidance, similar change in control concepts may be applied to partnership changes in control. This memorandum, however, discusses the rules as they relate to corporations.

A full discussion of the statute and interim guidance provided by the IRS with respect to the issues addressed by this memorandum is beyond the scope of this memorandum.

This memorandum is not intended to be a comprehensive summary of all issues relating to changes in control or corporate transactions under the Proposed Regulations. Clients should seek legal advice as to the application of the new rules to their particular arrangements by consulting with the lawyer who normally advises them with respect to such arrangements or one of the lawyers listed below. Such lawyers can also provide information necessary to access recent Teleconferences by Mayer, Brown, Rowe & Maw LLP attorneys discussing the new law and various transition rules and copies of other memoranda prepared by Mayer, Brown Rowe & Maw LLP relating to Section 409A.

The Proposed Regulations contain specific provisions that are applicable to change in control situations and other corporate transactions. In addition, issues relating to corporate transactions permeate almost every aspect of the deferred compensation rules. Accordingly, it is important to first determine what arrangements might constitute deferred compensation plans and then determine whether those arrangements satisfy the deferred compensation rules. This process generally needs to take place well in advance of a corporate transaction because Section 409A requires both operational and documentary compliance and, due to plan aggregation rules, failure to satisfy the requirements with respect to one of the arrangements may subject amounts under other aggregated plans to the sanctions of Section 409A even though those arrangements are otherwise in compliance with the rules.

It is also important in the context of a corporate transaction to ensure that whatever actions are being taken to complete the transaction do not inadvertently subject arrangements to the 409A rules if they previously were not so subject and/or violate the Section 409A rules with respect to arrangements that are otherwise subject to the rules. In addition, it will be important to try to fit the arrangements and the actions taken with respect to the arrangements within the business framework of the transaction without causing issues under the Section 409A rules. This will take a careful balancing of the business needs relating to the transaction and the application of the Section 409A rules.

Although a company currently may not be involved in a corporate transaction, there are many issues that need to be taken into account in the ordinary course of business that may be impacted by the change in control and corporate transaction provisions of the Section 409A rules, particularly with respect to plan design and agreements with executives pursuant to which benefits may be triggered upon or in connection with a change in control. For example, the Section 409A rules generally only permit payment of deferred compensation at specified times and/or upon the occurrence of specified events, one of which is a Change in Control Event (as defined below). Therefore, it is important to understand how those rules work so that a determination can be made as to whether and to what extent payments may be made under a company’s arrangements upon a change in control, how those rules may affect other payments under a company’s arrangements and whether any design changes are necessary and permitted prior to a change in control. A plan need not provide for payments on a Change in Control Event or all Change in Control Events but if a plan does provide for payments on one or more of these events, the event must satisfy the definition in the Section 409A rules.

There are generally three types of events that may constitute a Change in Control Event for purposes of the Section 409A rules:

• a change in the ownership of a corporation;
• a change in the effective control of a corporation; and
• a change in the ownership of a substantial portion of the assets of a corporation.

To constitute a Change in Control Event, the occurrence of the event must be objectively determinable (thus, provisions that provide that a change in control will occur when the board of directors or other person or group so determines will not be consistent with the rules) and any other condition, such as certification by a board or compensation committee, must be purely ministerial.

A change in the ownership of a corporation occurs on the date that a person (or group) acquires ownership of stock of the corporation that, together with stock already owned by such person or group, constitutes more than 50 percent of the total fair market value OR total voting power of the stock of the corporation (a "Change in Ownership Event"). If a person or group already owns more than 50 percent of the stock of a corporation, the acquisition of additional stock will not trigger a Change in Ownership Event. A Change in Ownership Event occurs only if there is a transfer or issuance of stock and the stock in such corporation remains outstanding after the transaction.

A change in effective control of a corporation occurs on the date that (1) a person (or group) acquires or has acquired during the 12-month period ending on the date of the most recent acquisition by such person (or group), ownership of stock of the corporation possessing 35 percent or more of the total voting power or (2) a majority of the members of the corporation’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the corporation’s board of directors prior to the date of the appointment or election (a "Change in Effective Control Event"). Note that the change in ownership component of a Change in Effective Control Event is limited to the voting power while many other definitions focus on voting power OR value, including the test for determining whether there is a Change in Ownership Event. Note also that a change in the board of directors triggers a Change in Effective Control Event only with respect to a corporation for which no other corporation is a majority shareholder. For example, if Corporation A is the majority shareholder of Corporation B and is a publicly held corporation with no majority shareholder and Corporation B is a majority shareholder of Corporation C, the provision relating to the change in directors applies solely to Corporation A and cannot constitute a Change in Effective Control Event for Corporation B or C.

If a person (or group) already has effective control of a corporation (i.e., owns at least 35 percent of the voting power), the acquisition of additional voting power does not trigger a Change in Effective Control Event or a Change in Ownership Event. Note that because the rules relating to a Change in Effective Control Event apply only to changes in voting power, the additional acquisition of value (for example, from 35% to more than 50%) could trigger a Change in Ownership Event. Therefore, if an entity already owns 35 percent of voting power of a corporation’s stock and acquires more voting power, a Change in Control Event will not be triggered solely because, at some point, the ownership level of the voting power reaches over 50 percent. If, however, the entity’s percentage ownership of the value increases from 35 percent to more than 50 percent, a Change in Ownership Event may occur.

A change in the ownership of a substantial portion of the assets of a corporation occurs on the date that a person (or group) acquires or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or group assets from the corporation that have a total gross fair market value of 40 percent or more of the total gross fair market value of all of the assets of the corporation immediately prior to such acquisition (an "Asset Sale Event"). Gross fair market value means the value of the assets of the corporation or the value of the assets being disposed of without regard to liabilities. An Asset Sale Event does not occur if the transfer is to an entity that is controlled by the shareholders of the transferring corporation immediately after the transfer or if a corporation’s assets are transferred to any of the following:

• a shareholder of the transferring corporation (immediately before the transfer) in exchange for or with respect to the receiving corporation’s stock;

• an entity in which the transferring corporation owns 50 percent or more of the total value OR voting power;
• a person (or group) that owns directly or indirectly 50 percent or more of the total value OR voting power of all of the outstanding stock of the transferring corporation; or
• an entity in which at least 50 percent of the total value OR voting power is owned directly or indirectly by a person that owns directly or indirectly 50 percent or more of the total value OR voting power of all of the outstanding stock of the transferring corporation.

The status of an entity is normally determined immediately after the transfer of the assets, except as noted above. Complex rules apply for purposes of attributing ownership in the context of Change in Control Events. For example, stock underlying a vested option is generally treated as owned by the holder of the option.

It is important to note that the definition of change in control for purposes of the Section 409A rules is not the same as the definition that applies for purposes of the golden parachute rules (although they are similar) and may be very different from what is currently included in a company’s plans and arrangements. Disparities in these definitions may raise issues for purposes of administering deferred compensation plans under the new rules.

If a plan permits distribution on a Change in Control Event, only employees with respect to the relevant corporation undergoing the Change in Control Event may receive a distribution of their deferred compensation as a result of the Change in Control Event. To determine which employees are affected by a Change in Control Event and who can therefore receive a distribution as a result of the event, it is important to determine which relevant corporations have had a Change in Control Event.

With respect to an employee, the relevant corporation is any of the following:

• the corporation for which the employee is performing services at the time of the Change in Control Event;
• the corporation(s) that is liable for the payment of the deferred compensation; or

• a corporation that is a majority shareholder of a corporation identified above or any corporation in a chain in which each corporation is a majority shareholder of another in the chain, ending in the corporation described above.

An entity is a majority owner if it owns more than 50 percent of the total fair market value AND voting power of another corporation.

To illustrate this concept, assume that Corporation A owns 100% of Corporations B and D and Corporation B owns 80% of Corporation C. A Change in Control Event with respect to Corporation B constitutes a Change in Control Event for employees of Corporations B and C (because the event occurs with respect to Corporation B and Corporation B is a majority shareholder of C) but NOT employees of Corporations A and D (unless the sale of B otherwise constitutes a Asset Sale Event because Corporation B is a substantial portion of Corporation A’s assets).

There are several areas of the 409A rules that may be implicated by a change in control or other corporate transaction. The following sections summarize some of the issues that may need to be addressed.

As discussed above, Section 409A provides that distributions can be made from deferred compensation plans to employees who are affected by a Change in Control Event. Another permissible event for distribution is a separation from service. In the context of a corporate transaction, it is important to determine when a separation from service occurs and whether, under the plan, payments are made on account of a separation from service, on account of a Change in Control Event or on account of some other event. It is important to note that distributions in connection with a change in control may be very closely intertwined with payments on a separation from service and it is not entirely clear how the rules are to be applied when the deferred compensation is payable upon the earlier or later of two dates that occur simultaneously, such as a change in control and separation from service. Care may need to be taken in drafting purchase agreements so that it is clear that one event occurs prior to the other–e.g., whether termination is to occur immediately prior to or immediately after the closing. This concept is particularly important because distributions to key employees (as defined in Section 416 of the Code) of public companies that are otherwise to be made upon separation from service must be delayed for at least six months following separation from service. The six month delay does not apply to distributions for other types of events, including distributions upon a Change in Control Event.

A separation from service for purposes of Section 409A generally means any termination of employment with the employer (that is, all the members of a controlled group of companies), subject to special rules for leaves of absence (generally 6 months or less).

Whether there has been a termination of employment is based on the facts and circumstances. If an employee continues in employment but the facts indicate that the intent of the parties is that the employee will provide only insignificant services (less than 20 percent of the average services performed by that employee for the immediately preceding three calendar years with less than 20 percent of the average annual remuneration during such three years), the employee will be treated as having a separation from service. If a former employee provides services to a former employer in capacity other than as an employee (e.g., pursuant to a consulting agreement), the employee will not be treated as having a separation from service if he provides services at an annual rate that is at least 50 percent of the services rendered during the preceding three calendar years with annual remuneration of at least 50 percent of the annual remuneration for that period.

Special rules apply for determining whether an independent contractor has had a separation from service. Generally, a separation from service in this context relates to whether the independent contractor has ceased to perform services under the contract pursuant to which the services are performed and the expectation of whether future services are going to be required under the agreement.

The Proposed Regulations also provide that the "same desk rule" does not apply for purposes of determining whether a person has had a separation from service. Thus, if a person has a bona fide termination of employment that otherwise satisfies the definition of a termination of employment for purposes of the Section 409A rules, the fact that the employee continues to provide substantially the same services for another employer is irrelevant in determining whether there has been a separation from service. In addition, employers cannot elect to apply the same desk rule. Thus, for example, if an employee’s employment with an employer is terminated in connection with a sale of assets and if the employer’s deferred compensation plan provides that distributions are to occur on termination of employment, the payments would need to be made even though the employee is working in the same job for the purchaser. It is not clear how the availability of the same desk rule will affect distributions from deferred compensation plans when responsibility for plans is transferred to a buyer in connection with corporate transactions or whether such transfers will be permitted without violation of the rules.

The separation from service rules need to be considered in the context of corporate transactions where employment and/or consulting agreements relating to post-transaction services are common and issues relating to payments on termination of employment are also likely to arise.

As mentioned above, in the case of public companies, separation from service distributions to key employees must be delayed for at least six months from the separation from service. Generally, a corporation’s key employees are to be determined based on a 12-month period ending on a date chosen by the employer. Persons who meet the definition during that 12-month period are considered key employees for the 12-month period commencing on the first day of the 4th month following the end of that 12-month period. Thus there is a three month delay to permit employers to identify the key employees for the relevant period. In the context of a corporate transaction, special rules apply to the determination of key employees:

• In the case of a spin-off of a new corporation or entity from a public corporation (called the "old corporation"), any person who was a key employee of the old corporation is treated as a key employee of the new corporation through the end of the 12-month period beginning on the first day of the 4th month following the old corporation’s last key employee identification date preceding the spin-off transaction. For example, if a spinoff occurs in 2006 and the old corporation had a calendar year determination period with a key employee identification date of December 31, key employees of the old corporation will be treated as key employees of the new corporation through March 31, 2007, which is the last day of the 12-month period beginning on the first day of the fourth month following the old corporation’s last identification date preceding the spin-off (December 31, 2005).

• Where two corporations are merged or otherwise become part of the same controlled group (e.g., in the case of a stock purchase), any person who was a key employee of either of those two corporations immediately before the merger will be treated as a key employee of the combined entity until the first day of the 4th month after the identification date of the merged entity following the merger.

• The proposed rules generally provide that once the method of complying with the 6 month delay is established (for example, delaying the start of payments for 6 months following separation from service), that method may be amended but the amendment may not be effective for 6 months. Because the 6 month delay only applies to companies that are publicly traded the Proposed Regulations permit a plan of an entity that is not publicly traded but that needs to add the period because it is going to become public (such as would be the case with an initial public offering (IPO)) to be amended to implement the 6 month delay rule effective immediately upon adoption of the amendment. It is not clear how the restriction on changing the period applies where there is a merger or other combination of two companies that may have had different determination periods prior to the combination. In addition, it is not clear how the determination of key employees is to be made in connection with an IPO. Presumably, when the IPO occurs, the company would need to establish and apply a determination period.

Another type of payment provision that relates to corporate transactions is an earn-out payment. Generally, the Section 409A rules permit payments of deferred compensation only on a fixed date or pursuant to a fixed schedule or on account of specified events. In addition, deferral elections must be made in accordance with very stringent rules.

Compensation that is payable pursuant to the purchase by a company of stock or a stock right (option or SAR) held by an employee or payments of deferred compensation calculated by reference to the value of employer stock may be treated as paid at a specified time or pursuant to a fixed schedule if such compensation is paid on the same schedule and under the same terms and conditions as payments to shareholders generally pursuant to a Change in Ownership Event or payment to the employer pursuant to an Asset Sale Event. These payments will not be treated as violating the initial or subsequent deferral rules if such amounts are paid not later than 5 years after the applicable Change in Control Event. Note that payments in connection with a Change in Effective Control Event are not covered by these special rules. Also, these rules do not appear to apply to amounts that are not based on the value of the company’s stock or otherwise relate to the value of the company’s stock, such as performance bonuses based on the sale value of assets.

The rules under Section 409A generally prohibit acceleration of the payment of deferred compensation. Apart from actions permitted under the transition rules for 2005, termination of a plan and payment of all deferred amounts would be treated as an impermissible acceleration of payment unless very onerous rules are met (for example, that all plans of the same type are terminated for all participants and no new plans of that type are implemented for a period of 5 years after termination).

An exception to the general rule is available for plan terminations in connection with a Change in Control Event. Under this exception, the employer may retain the discretion under the terms of the plan to terminate a plan if the termination occurs within 30 days prior to OR within 12-months following a Change in Control Event. This exception is available only if all substantially similar arrangements that are sponsored by the employer (apparently determined on a controlled group basis) are terminated so that the participant and all participants in substantially similar arrangements are required to receive all amounts of compensation under those arrangements within 12 months following termination of the arrangements.

Unlike other situations where arrangements can be terminated, the change in control termination exception does not appear to restrict participation by plan participants in future arrangements and does not require termination of all plans of the same type. Rather, it appears to apply only to arrangements that are "substantially similar", although the Proposed Regulations do not contain a definition of that term. Although it is not entirely clear, it appears that an employer’s "substantially similar" arrangements are determined at the time of plan termination. Thus, the timing of the termination (whether before or after the Change in Control Event) may impact which arrangements are "substantially similar" and which arrangements must therefore be terminated.

It is common in the context of a corporate transaction to modify in some way outstanding stock rights of the target, the acquirer or both. Also, stock rights may be modified in the context of a corporate transaction by operation of agreements that may be in place, such as change in control agreements. All changes to the rights should be analyzed under Section 409A.

Generally, any modification of a stock right is treated for purposes of Section 409A as the grant of a new right on the date of the modification. If the modification is an extension or renewal of the stock right, the right is treated as having a deferral feature from the date of the original grant, thus causing it to be subject to Section 409A from the date of grant. For purposes of Section 409A, a "modification" means any change in the terms of a stock right (including a change in the arrangement pursuant to which the right was granted, such as the "plan") that may provide the holder of the right with a direct or indirect reduction in the exercise price or an additional deferral feature or an extension or renewal of the stock right, regardless of whether the holder benefits from the change. An "extension" is the grant to the optionholder of an additional period of time to exercise the stock right (beyond the time originally prescribed, subject to certain permitted limited short term extensions). A "renewal" of a stock right is the granting of the same rights or privileges contained in the original stock right on the same terms and conditions. For example, if, after an option is granted, a corporation and an executive enter into a change in control agreement that provides for a longer exercise period following a change in control and if that longer exercise period was not included in the original grant, the changes to the option made by the change in control agreement would be considered a modification of the option and would most likely be viewed as an extension, thus causing Section 409A issues regardless of whether the executive ever benefits from the changes.

Notwithstanding the general prohibitions on modifications, the Proposed Regulations permit the substitution of stock rights in the context of a corporate transaction without treating that substitution as a modification of the underlying award or as a change in the form of payment. In addition, a substitution that is made in accordance with the rules will cause the stock subject to the substituted option to be treated as "service recipient stock" for purposes of the Section 409A rules. This is important because one of the requirements for a stock right to be outside the scope of Section 409A is that the right be granted with respect to "service recipient stock". In order to avoid issues under Section 409A, any substitution must satisfy certain requirements.

In the Section 409A context, compliance with the substitution rules relating to incentive stock options ("ISOs"), including applying those same principles to options that are not ISOs, will not be treated as a modification. (As long and to the extent that they meet the requirements of Section 422 of the Code, ISOs are not themselves subject to Section 409A.) This has traditionally been a very common method for the conversion of options in the context of a corporate transaction (including for non-ISOs). That method generally involves the modification of the number of shares subject to the option and the corresponding exercise price so that the optionholder retains the same value under the option after the conversion as he or she had prior to the conversion. In addition, those rules require that, on a share by share comparison, the ratio of the exercise price to the fair market value of the shares subject to the option immediately after the substitution cannot be more favorable than the ratio of the exercise price to the fair market value of the shares subject to the option immediately prior to the substitution.

Although the Proposed Regulations provide that compliance with the ISO substitution rules will be acceptable, the regulations also provide that the ratio test need not be applied on a share by share basis as it is for ISOs but rather it may be applied on an aggregate basis. The ISO rules, however, would continue to apply to ISOs in order to satisfy tax rules other than Section 409A.

It is important to note that in the context of a spin-off transaction involving two public companies (apparently regardless of whether the test is being applied in a manner that is consistent with the ISO rules or under the more generous Section 409A rules), the determination of whether the ratio test is met may be made by using market quotations as of a predetermined date that is not more than 60 days after the transaction or based on an average of market prices over a period of not more than 30 days ending not later than 60 days after the transaction. For example, if a company spins off the stock of a subsidiary to its shareholders and the new independent company will be assuming options of the prior parent but substituting its own stock under the options, the adjustment could be based on the average price of the new public company’s stock for the 30 day period immediately after the spin-off. Of course, the practical problem will be that it will not be possible for option exercises to occur during the averaging period because it will not be possible to determine what the exercise price will be.

In addition to the substitution of option rights, there are other types of changes to stock rights that are common in the context of corporate transactions. Many of these common changes will continue to be permitted under Section 409A. Some of the more common changes that are addressed by the Proposed Regulations include the following:

• The acceleration of the date on which a stock right is exercisable (such as upon a change in control, regardless of whether the definition satisfies the definition of a Change in Control Event) is not, in and of itself, a material modification, regardless of whether the acceleration provision was included as part of the original grant.
• Generally, an increase in the number of shares subject to an option is not treated as a modification but rather is treated as a new grant with respect to the increased number of shares. An exception to this general principle applies if the increase is as a result of a stock split (or reverse stock split) or stock dividend, there is a corresponding proportionate adjustment to the exercise price and number of shares subject to the stock right and the only effect of the split or dividend is to increase or decrease, as applicable, on a pro rata basis the number of shares owned by each shareholder of the applicable class of stock and the aggregate exercise price of the stock right is not less than the aggregate exercise price before the stock split or dividend.
• It is not a modification to add a provision permitting the exchange of a stock right for cash equal to the amount that would be available if the right were exercised—i.e., the spread.
• Certain tolling of exercises which then result in an extension of the exercise period are not treated as an extension for purposes of Section 409A. Specifically, tolling because the exercise would violate securities laws is permitted so long as the right may be exercised no later than 30 days after the exercise would no longer violate securities laws. Note that this does not apply to extensions necessary to comply with insider trading policies which may be more restrictive than securities laws or other mutually agreed upon exercise restrictions where the exercise would not otherwise violate securities laws.

Issues under Section 409A are raised by the provisions of change in control agreements, i.e., agreements that provide enhanced benefits in connection with a change in control, either as a result of the change in control or, as is more typical, upon a termination of employment within some specified period following a change in control.

One of the first questions that needs to be addressed in the context of a change in control agreement is whether the agreement provides for deferred compensation.¹ Generally, a person would have a legally binding right to payments under a change in control agreement when the agreement is established (either unilaterally or by agreement of the parties) and payments under the agreement would generally be payable in a later year. Therefore, it would be expected that change in control agreements would normally fit within the definition of a deferred compensation plan for purposes of Section 409A.

The second question that must be addressed is whether the payments under the agreement fall within any of the exceptions to deferred compensation, including the grandfather provisions and short term deferral rules.

Payments under the agreement will be grandfathered if the agreement was in place as of October 3, 2004, the amounts payable under the agreement were "earned and vested" as of December 31, 2004 and there is no material modification of the agreement after October 3, 2004. For this purpose, an amount is "earned and vested" only if it is not subject to a substantial risk of forfeiture (using the definition applicable for purposes of Section 83 of the Code, not the definition that is otherwise used for Section 409A). Under that definition, it is highly unlikely that traditional change in control agreements would be grandfathered as the person must either continue to perform services in order to receive the payments, a change in control must have occurred, or both.

Assuming that payments under a change in control agreement are not grandfathered, other exceptions to the general Section 409A rules should be explored. One such exception is the short term deferral rule. Under that rule, amounts are not treated as deferred compensation for purposes of the Section 409A rules if, at all times under the arrangement (absent an election to further defer), amounts are paid within 2-1/2 months after the close of the year in which the amounts cease to be subject to a substantial risk of forfeiture (within the Section 409A meaning of that term). Generally, amounts payable under a typical change in control agreement should be treated as being subject to a substantial risk of forfeiture for purposes of the Section 409A rules until the change in control occurs. Thus, if the agreement is a single trigger (i.e., payments are made based on the occurrence of the change in control without regard to whether the person terminates employment) and if the payments are made in accordance with the 2-1/2 month rule, the agreement should fit within the exception for short term deferrals. Although this is not the way in which most change in control agreements are structured, it may be possible to structure an arrangement to comply with these rules. If the agreements are double trigger agreements (i.e., payments are made only if there is a termination of employment following a change in control) and if, as is very common, the agreement provides for payments if the executive terminates employment for "good reason", it is likely that the IRS would take the position under the current guidance that the amounts cease to be subject to a substantial risk of forfeiture as of the date of the change in control even if no termination occurs on that date. Given that payments under a double trigger agreement would not be made until there is a termination of employment, it is unlikely that the agreement would satisfy the requirements for the short term deferral exception and, therefore, it is likely that the agreement would be treated as providing deferred compensation subject to Section 409A.

It is important to note that the Proposed Regulations do not address whether a "good reason" termination provision is a substantial risk of forfeiture and the preamble addresses this issue by stating that the regulations do not categorically treat a right to payments upon a good reason termination as subject to a substantial risk of forfeiture. If presented with the right factual situation, it may be possible to treat such a right as subject to a substantial risk of forfeiture, particularly during a good faith compliance period. Further, the IRS has asked for more comments on this issue.

Another exception to be explored is the exception for severance pay arrangements. Aseverance pay arrangement is defined as any arrangement that provides for separation pay or, if an arrangement provides separation pay in addition to other benefits, a severance pay arrangement includes the portion of that broader arrangement that provides for separation pay.

Separation pay means any amount of compensation where one of the conditions to the right to the payment is a separation from service, whether voluntary or involuntary, including payments in the form of reimbursements of expenses and the provision of "other" taxable benefits. The suggestion here, confirmed by the IRS informally, is that if nontaxable benefits are provided (for example, non-taxable medical benefits), those benefits would not be treated as reimbursements subject to the severance pay rules.

It is possible that some change in control agreements may fall within the severance pay exception. Generally, a severance pay arrangement will not be subject to Section 409A if the arrangement (1) provides for severance pay upon an actual involuntary separation from service, (2) limits the amount of severance pay (not including certain types of reimbursements) to two times the employee’s annual compensation or, if less, two times the limit that is taken into account under Section 401(a)(17) of the Code (which is $205,000 for 2004; $210,000 for 2005) for the calendar year preceding the year of the termination, and (3) provides that all payments will be made no later than the end of the second calendar year following the year in which the employee terminates service.

The exception does not apply to the extent that the payments are a substitute for or replacement of deferred compensation. For example, payments do not fall within this exception if the payments of severance are made only in exchange for the employee’s waiver of a right to payment of deferred compensation. Therefore, care needs to be taken in analyzing the payments under the agreement.

Another component of change in control agreements that should explored is the common provision of providing outplacement services and/or an extended period of participation in a health plan or other types of continuing benefits. Presumably, these types of payments would be vested at the same time the right to severance payments is vested. Thus, if the right to reimbursement extends more than 2-1/2 months after the year in which the right becomes vested, the reimbursements would need to be analyzed under Section 409A. The Proposed Regulations, however, provide a separate exception for these types of arrangements if they are related to termination of services. Specifically, the Proposed Regulations provide that to the extent that the reimbursement arrangement covers only expenses incurred AND reimbursed before the end of the second calendar year following the calendar year in which the termination occurs, these amounts will not be subject to Section 409A. Although it is not entirely clear from the Proposed Regulations or the preamble thereto, the IRS has stated informally that amounts that are otherwise excludable from income (such as nondiscriminatory health benefits) are not subject to the foregoing restrictions. For example, a common benefit to be provided in connection with change in control agreements is continuing health benefits. Under certain types of arrangements, these benefits may be taxable to the executive (e.g., where the benefits are provided under a self-insured health plan and the benefits are discriminatory). Therefore, it is possible that continuing health benefits would be subject to Section 409A. Because payment of these benefits would not normally meet the requirements of Section 409A (because, for example, they are not paid on a fixed date or on account of a specified event that falls within the rules), it would be important to cause the benefits to fit within the exception, either by limiting the period during which they are provided (taking into account that the limited period applies to both when the claims are incurred AND when the reimbursement is made) or by providing the benefits in a non-taxable manner.

In-kind benefits that would be exempt from the Section 409A rules (such as in-kind outplacement) would also satisfy the exception described above if a right to reimbursement of the same benefits would be treated as exempt from Section 409A.

Reimbursement type payments that do not exceed $5,000 in the aggregate during any taxable year are also excluded.

Generally, in the case of an arrangement that otherwise provides for short term deferrals, a deferral election can be made if certain requirements are met. The general rule for these types of deferrals is that the date on which the amount is no longer subject to a substantial risk of forfeiture (determined under the Section 409A rules) is treated as the original payment date and any further deferral must be for a period of at least 5 years after that date and must otherwise be made in accordance with the further deferral rules of Section 409A. Notwithstanding the general 5 year rule, an initial deferral election with respect to short term deferrals can permit distribution on a Change in Control Event, even if the Change in Control Event occurs prior to the expiration of the 5 year deferral period. This is important because this is not permitted for other events, such as separation from service.

There are special rules that apply for making deferral elections when the employer has a fiscal year other than the calendar year. Generally, those require that a deferral election with respect to compensation paid for a fiscal year must be made in the fiscal year prior to the fiscal year in which any services are performed for which the fiscal year compensation will be payable. The Proposed Regulations do not provide special deferral rules that apply in this situation in the context of a corporate transaction. Therefore, if there is a change in the fiscal year as the result of a corporate transaction, it appears that the ability to defer fiscal year compensation for the fiscal year in which the transaction occurs may be limited. For example, assume that a company with a calendar year fiscal year is merged on November 1 with another company that has a fiscal year that began on October 1 and that the fiscal year for the surviving entity will be October 1 through September 30. Under the Proposed Regulations, deferral elections for the post-closing fiscal year would have to have been made by September 30. Therefore, employees who were not employees of the surviving entity prior to the closing and who, therefore, did not make elections prior to October 1 would not be able to make deferral elections with respect to any current fiscal year arrangements of the surviving entity for which they may become eligible upon the closing the merger.

There are special deferral rules that apply for an employee’s first year of eligibility in plans of the same type (e.g., all account balance plans). Generally, if an employee is already a participant in a plan of a certain type (e.g., an account balance plan), the special rule for initial deferrals will not be applicable to participation in any other plan. There are no special rules that provide that the special initial eligibility rules "restart" when the composition of the controlled group employer changes due to a corporate transaction. Therefore, absent some other exception or further guidance, it may be not be possible to permit elections based on the special initial eligibility rules if the employee already participates in a plan within the controlled group. For example, assume that Employer A maintains an account balance plan in which Employee 1 participates. Further assume that, in connection with a corporate transaction, Employer A becomes a subsidiary of Employer Z and Employer Z maintains its own account balance plan that will be extended to Employee 1. Because Employee 1 already participates in an account balance plan and because there are no special rules for initial deferral elections in the context of a corporate transaction, Employee 1 would be precluded from making deferral elections under Employer Z’s plan under the initial deferral election rules

Generally, the Proposed Regulations provide special rules for deferrals with respect to performance-based compensation that apply if the employee performed services continuously from a date no later than the date on which the performance criteria are established through the date of the initial deferral election. The Proposed Regulations do not contain special rules with respect to elections relating to performance-based compensation in the context of a corporate transaction. Further, the Proposed Regulations do not address how the rules are to be applied if, on the date that the applicable performance criteria were established, the employee was employed by an entity that subsequently becomes part of the same controlled group as the entity that will paying the performance-based compensation. For example, assume that Employee 1 is continuously employed by Employer X from January 1 of a year and that Employer X becomes a subsidiary of Employer Z on February 1. Further assume that Employer Z has a performance bonus plan that will cover employees of Employer X from the closing date and that the targets were set as of January 1. The rules do not address whether Employee 1 would be entitled to make a deferral election under Employer Z’s plan in accordance with the special rules for performance-based compensation with respect to Employer Z’s plan since he was not employed by Employer Z (or its pre-closing controlled group) throughout the relevant period.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Mayer Brown is a combination of two limited liability partnerships: one named Mayer Brown LLP, established in Illinois, USA; and one named Mayer Brown International LLP, incorporated in England.