This article continues with another tip for drafting executive employment agreements and the importance of consulting counsel.
For every well drafted executive employment agreement in the business world, there seem to be multiple, poorly drafted agreements. Too often, employers simply copy and paste from older agreements without knowing anything about the identity or qualifications of the author of the original agreement, the jurisdiction, or circumstances in which the agreement was intended to be used. Moreover, employers sometimes borrow terms from an agreement that was heavily negotiated by an executive with considerable leverage. Under such circumstances, the agreement likely will contain terms that are less favorable to the employer than those that can be negotiated with another executive. Most employers do not realize their mistakes until they are consulting an employment attorney regarding their rights and obligations with respect to an executive who has engaged in misconduct or is simply performing poorly. The purpose of this series is to provide tips for drafting executive employment agreements and to highlight the importance of consulting counsel before tendering an agreement to an executive for consideration.
Tip No. 4: Beware of 409A
When drafting executive employment agreements, it is imperative to consider the potential implications of Section 409A of the Internal Revenue Code of 1986, as amended (“Section 409A”). Section 409A is a U.S. tax law which governs the payment of deferred compensation (i.e., compensation earned in one year that is payable in another year). This law generally regulates the time, form and manner in which deferred compensation is paid and imposes severe penalties on the executive for a failure to comply. These penalties generally include payment of income tax on any amounts deferred under the agreement retroactive to the first year the agreement violated Section 409A, interest on the unpaid taxes and an excise tax equal to 20% of the income recognized. Although it is the executive, and not the employer, who is penalized under Section 409A, the executive’s counsel typically will raise the issue. Thus, even if the employer does not believe that its duty of good faith and fair dealing requires bringing this issue to the attention of the executive, it is typically more efficient to draft the employment agreement to comply Section 409A in the first instance so that the negotiations can focus on the terms in dispute.
While a detailed discussion of Section 409A’s triggers and loopholes is beyond the scope of this article, employers should keep in mind for issue-spotting purposes the following potential triggers for Section 409A liability:
- Including payment periods that extend longer than 90 days;
- Not including a six-month delay in payments made on account of termination of employment if the executive is a “specified employee” of a public company (Note, while this provision only applies to public companies, Section 409A applies to both private and public companies);
- Including a non-compliant definition of “good reason” (when the intent is to rely on the “involuntary termination” exemption from 409A); and
- Making payments contingent on receipt of notice or evidence of the executive’s death.
Legal counsel experienced with drafting Section 409A-compliant executive employment agreements can avoid potential liability in a number of ways (e.g., including “safe harbor” provisions, restructuring the agreement). Accordingly, employers should always consult counsel with Section 409A expertise when an executive employment agreement provides for any form of deferred compensation.