Last month, the IRS provided helpful guidance under Code Section 409A with the release of its Chief Counsel Advice 201645012 (the CCA). The CCA is noteworthy because the IRS agreed that a 25% increase qualified as a materially greater amount, and thus deferred salary was subject to a substantial risk of forfeiture. The CCA may not be used or cited as precedent, but still gives good insight as to how the IRS might respond to similar facts and circumstances.
In the CCA, an employee made an election in November 2014 to defer a portion of 2015 salary. The salary would be paid on January 1, 2018, but only if the employee continued to provide substantial services through December 31, 2017. In connection with the salary deferral, the employee received a matching contribution that increased the present value of the salary by 25%. The question posed in the CCA was whether the prospect of an additional 25% would allow the deferred salary to be subject to a “substantial risk of forfeiture” for purposes of Section 409A through December 31, 2017. The IRS agreed that it would.
Brief Background on Section 409A
At its most basic level, Section 409A requires that parties who wish to defer compensation declare, at the outset, exactly when compensation will be paid in the future, and then forces the parties to live up to that commitment. More technically, Section 409A (i) requires that any election to defer compensation must be made by certain deadlines, (ii) restricts payment of the compensation to certain objective payment triggers, and (iii) generally prohibits the parties from accelerating or further deferring the payment. A violation of Section 409A typically results in the service provider (e.g., the employee) recognizing immediate income tax, a 20% penalty, and potentially other fines and penalties.
Background on Substantial Risk of Forfeiture
The phrase, substantial risk of forfeiture (SRF), is loosely understood as a vesting condition and is one of the most important concepts throughout Section 409A. The negative tax consequences noted above do not apply while an amount remains subject to an SRF and there are certain ways to correct Section 409A violations that are available only while an amount remains subject to an SRF. Even more powerful, however, is an exemption from Section 409A known as the short-term deferral exception, which turns on the definition of SRF. Short-term deferrals are best understood as a pay-when-vest arrangement. So long as a payment occurs once (or soon after) the SRF lapses, the arrangement generally is exempt from the onerous rules of Section 409A. A traditional retention bonus is the most straight-forward example of a short-term deferral.
No Extension of SRF
Section 409A generally prohibits parties from extending an SRF, rightly assuming that an employee would not agree to extend a vesting condition unless the purpose was to delay recognition of tax. However, the addition or extension of an SRF will be honored if the present value of the amount subject to the additional SRF is materially greater than the present value of the amount the service provider otherwise could have elected to receive absent such risk of forfeiture.
What is Materially Greater?
Practitioners have debated what level of additional compensation would be sufficient to satisfy the “materially greater” threshold. The CCA suggests that any amount that is at least 25% in excess is sufficient. Any increases less than 25% now raise additional risk and should be discussed with counsel.
Timing of Extension?
The facts of the CCA involved a deferral election in 2014 with respect to 2015 salary. Readers familiar with Section 409A will recognize that this election timing complies with Section 409A’s general rule that deferral elections occur no later than the end of the calendar year before the year in which the applicable services are rendered. Note, however, that nothing in the regulations requires that an extension of an SRF occur by any certain date. That flexibility to extend an SRF outside of 409A’s election timing rules may be useful in several circumstances.
Helpful for Troubled Companies?
The CCA may reduce the 409A risk faced by cash-strapped (usually smaller) companies that determine in the middle of a calendar year that salary payments are problematic. The CCA suggests that, so long as those companies are willing to pay a materially greater amount in the future, deferring salary may be done without violating Section 409A. Moreover, these arrangements presumably would remain short-term deferrals and could be accelerated without violating Section 409A.