WARNING:  Section 409A May Be Dangerous to the Health of Your Portfolio

Although an inquiry into the existence and nature of deferred compensation arrangements, change in control agreements, incentive compensation programs and severance packages is almost always an important due diligence item for venture capital and private equity firms contemplating an investment in a portfolio company, a careful review of these arrangements has become even more important as a result of recent tax law changes that will affect, in some cases quite dramatically, the companies providing for such arrangements. 

The American Jobs Creation Act, passed by Congress and signed by the President at the end of 2004, added Section 409A to the Internal Revenue Code.  Section 409A imposes strict limitations on the timing of deferral elections, the ability to change elected forms of payment, the timing and manner of permitted payments, and the funding of deferred compensation.  Arrangements that fail to satisfy Section 409A may subject individuals to liability for (i) additional income tax, (ii) interest, and (iii) a surtax equal to 20% of the amount included in income.  Section 409A also imposes additional reporting requirements on employers and may subject an employer to penalties if it does not withhold income taxes at the appropriate time and in the appropriate amounts.

Section 409A applies to many arrangements that traditionally may not have been thought of or treated as deferred compensation plans, many of which arrangements are often used by illiquid start-up and early-stage companies which are seeking venture-backed financing. For example, Section 409A applies to stock appreciation rights, phantom stock, restricted stock units and discounted stock options (i.e., options with an exercise value less than the date of grant value), as well as employment contracts, severance and change in control agreements, and incentive compensation programs. 

The following discussion summarizes the key provisions of Section 409A:

Prohibition on Acceleration of Payments

Section 409A prohibits a plan from permitting the acceleration of payments and may affect certain distributions when a plan is terminated.  Acceleration may be permitted in certain circumstances such as:  to comply with a domestic relations order, to comply with federal rules against conflicts of interest, to pay employment (i.e., FICA and Medicare) taxes, and to provide limited lump-sum payments upon termination of employment.

Distribution Provisions

Section 409A limits distributions from a nonqualified deferred compensation plan to certain events such as:

Election Timing

Section 409A imposes new restrictions regarding the timing of deferral elections.  Generally, an election to defer compensation must be made before the beginning of the year in which the compensation is earned, although special rules apply to performance-based compensation and first-year elections.  Special rules also apply to subsequent modifications of an initial deferral election and elections made during 2005. 

Funding Arrangements

Section 409A imposes new restrictions regarding how deferred compensation plans are funded.  For example, the use of offshore trusts to fund a plan, funding arrangements that depend upon a change in the employer's financial health, and certain other funding arrangements may trigger immediate taxation and penalties. 

Effective Date

Section 409A applies to compensation that is deferred after December 31, 2004, as well as compensation deferred before December 31, 2004 that becomes vested after that date.  In some circumstances, Section 409A may apply to amounts deferred and vested before 2005.  In addition, plan amendments made during 2005 may be permitted in certain circumstances. 

Transitional Rules

The IRS has issued several special rules for 2005 to allow employers time to comply with the new requirements of Code Section 409A.  In some cases, plans may be terminated or amounts distributed under the plan in 2005.  Additionally, a plan may allow participants to make new payment elections in 2005 with respect to amounts deferred before the election and may allow some or all participants to terminate participation in the plan or cancel a deferral election during 2005.

 
 
For more information regarding Section 409A and its application, please contact Thomas F. Schnellenberger or Michael Buker.