When drafting employment agreements and severance arrangements for employees of US subsidiaries or for Canadian-based employees who are US citizens, it is important to have US benefits counsel review the draft agreement in order to ensure compliance with Section 409A of the US Internal Revenue Code. Severance and bonus provisions are especially tricky. Many common provisions, such as a requirement to pay the executive severance upon termination, or the ability of the executive to quit and be entitled to severance upon a change of control, without further magic language required by Section 409A (such as a provision requiring a six month delay prior to making any such payment) can result in the executive being required to pay the IRS an additional 20% tax, over and above normal tax requirements, on the severance payment, regardless of the circumstances in which the payment was actually made. Key executives of companies who have failed to conduct this review of the agreement have found, upon the occurrence of a change of control or other severance event, that they are subject to tens of thousands, and in some cases hundreds of thousands, of dollars of extra tax for no reason other than the way in which the agreement was drafted. Because the tax is a tax on the executive, executives are particularly unhappy to hear their agreement was not properly drafted.
If the agreement was not reviewed prior to adoption, it may still be possible to amend the agreement to eliminate or at least reduce the tax that the executive must pay; however, this should be done as early as possible because it must be done prior to a triggering event, and in some cases the “fix” is subject to a cooling off period.
In addition, companies should be mindful of Section 280G of the U.S. Internal Revenue Code, which (1) disallows a company’s tax deduction for the payment of compensation and (2) charges a 20% excise tax to the individual, for payments received by certain officers (and, in some cases, directors) in connection with a change in control that exceed an amount determined by a formula in the statute. For these purposes, payments may include severance payments, accelerated bonus payments, health care continuation costs, acceleration of equity awards, as well as retention awards with the acquiring company. For this reason, US employment agreements are often drafted to cap the amount an individual may receive as the result of a change in control or, alternatively, to provide a 280G tax gross-up to the individual. Unlike publicly traded companies, private companies have the opportunity to eliminate these negative tax consequences by disclosing the amount of the payments that would violate 280G and having the shareholders approve the payments. It is important to speak with U.S. benefits counsel about the potential impact of Section 280G both when drafting such an agreement and when considering a potential change in control.