REITs Executive Compensation Guide

Section 409A

Provisions encountered in employment agreements, offer letters and severance plans and agreements that typically raise the most prominent Section 409A issues are those relating to severance payments, as they almost invariably provide for a legally binding right to compensation that is or may be payable in a later year. Thus, such severance payments must either (i) comply with the requirements of Section 409A or (ii) be structured to fall within an exemption from Section 409A (e.g., the “short-term deferral” exemption or the “involuntary separation pay” exemption). PRACTICE POINT: Unless an exemption applies, severance payments and benefits generally constitute deferred compensation under Section 409A and thus are subject to the entire body of regulations under Section 409A. There are a number of conditions that must be met for an exemption to apply, and modification of an agreement can cause otherwise exempt severance to become subject to Section 409A. Accordingly, Section 409A implications should be considered any time an employment or severance agreement is amended, particularly if the amendment affects the conditions required to trigger severance or the time or form of payment of the severance.

Under Section 409A, amounts deferred under a nonqualified deferred compensation plan are currently includible in gross income to the extent not subject to a substantial risk of forfeiture, unless the plan complies with the requirements of Section 409A, in both form and operation. To the extent any amounts do not comply with the requirements, they may be subject to severe penalties, including an additional 20% federal tax. Employers are often surprised by the reach of Section 409A, as the term “nonqualified deferred compensation plan” reaches far beyond traditional deferred compensation plans. Indeed, Section 409A covers any plan, agreement, method, program or other arrangement that provides for deferral of compensation, and it can apply to compensation arrangements with consultants and directors, as well as employees. A plan generally provides for the “deferral of compensation” if the recipient has a “legally binding right” to compensation during a taxable year that is or may become payable in a later year. Accordingly, an employment agreement, offer letter, severance agreement or plan, consulting agreement or any other plan or agreement providing for compensation of any nature that may be paid in a future year may potentially be subject to Section 409A.

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