How Does Section 409A Affect Incentive Compensation by LLCs Taxed as Corporations?

Welcome, esteemed readers, to the 15th installment of our in-depth series on incentive compensation for LLCs taxed as corporations! We applaud your dedication in joining us on this journey to fully understanding the intricacies of incentive compensation. Now, we are three-quarters of the way through, with only five articles remaining. Today, we turn our attention to Section 409A of the Internal Revenue Code, a pivotal statute that significantly impacts how incentive compensation operates. Much like a complex jigsaw puzzle, our understanding of incentive compensation is incomplete without fitting this essential piece into its rightful place. Let’s dive in, shall we?

Understanding Section 409A

Section 409A of the Internal Revenue Code serves as the compass guiding non-qualified deferred compensation plans. Similar to a strategic business plan that allocates resources for future growth, a deferred compensation plan lets members set aside a portion of their earnings for future payout. However, just as the success of a business plan depends on diverse variables, whether a compensation plan falls within the scope of Section 409A is determined by a multitude of factors, making the rules complex and at times, elusive. Owing to this intricacy, companies often devise their compensation plans to elegantly sidestep Section 409A’s demanding provisions.

Below are some of the rules encompassed under section 409A:

• Initial Deferral Elections: Subject to certain exceptions, participants must declare their intent to defer compensation before the commencement of the year in which the associated services will be performed.
• Permissible Distribution Events: Stipulates specific events at which distributions from a deferred compensation plan can occur. These include separation from service, disability, death, or unforeseen emergencies.
• No Acceleration of Payments: The company is disallowed from hastening the payment of deferred compensation, thereby curtailing potential tax avoidance strategies.
• Subsequent Deferral Elections: Provides specific guidelines for participants wishing to make additional deferral elections. Notably, the new payment date must be at least five years later than the original payment date, and the election must be made at least 12 months before the initial payment date.

The Impact on Incentive Compensation Plans

Deferred incentive compensation plans can take a variety of forms, including stock options, stock appreciation rights, phantom stock, and performance share units. With respect to phantom stock and performance share units, companies usually take great care to ensure these compensation plans are structured in a way that exempts them from the intricate rules of Section 409A.

On the other hand, the strategy for avoiding Section 409A is more straightforward for stock options and stock appreciation rights. The determination of whether these types of incentive compensation fall under 409A’s umbrella is based on the exercise price. When the exercise price matches or exceeds the Fair Market Value (FMV) of the underlying stock at the time of the grant, these awards can sidestep Section 409A’s complex rules. But if the exercise price falls below the FMV, these awards come under Section 409A’s scrutiny.

Preparing for a potential change in control maneuver, companies often engage in discussions with executives and management team members regarding bonuses tied to a change in control and amplified severance terms for certain employment terminations within a specific timeframe post-change. These pre-emptive agreements involving change in control bonuses and enhanced severance conditions are typically considered deferred compensation under Section 409A. Unless exempted or exceptional, these arrangements present substantial compliance challenges under Section 409A.

Consider this: Section 409A explicitly outlines 'Change in Control' events, which have the capacity to activate such bonuses and bolstered severance arrangements. These transformative moments may arise when a party or coalition secures over 50% of the company's total fair market value or voting power, a majority turnover occurs in the board of directors, or a considerable proportion of the company's assets are sold. The regulations are intricate and demand companies to comprehend the stipulations and structure their compensation arrangements suitably, well ahead of a control change.

A word of caution to companies: the penalties for non-compliance with Section 409A are quite severe. Even though setting the exercise price at FMV can make an award exempt from Section 409A, an incorrect FMV calculation can impose a hefty penalty on the recipient—20 percent, plus interest, on the taxable value. This underscores the importance of accurately determining the FMV, a topic we’ll delve deeper into in our next installment. Just as a construction manager ensures the building’s foundation is solid before proceeding with the construction, a company should also confirm the accuracy of FMV before granting stock-based compensation.

Conclusion

We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.

As we continue unraveling the complexities of incentive compensation, our next article will shine a light on the critical aspect of company valuation, the cornerstone of structuring effective incentive compensation plans. Don’t miss out on this vital insight - join us in the 16th installment as we demystify ‘Valuing a Company for Incentive Compensation Purposes in LLCs Taxed as Corporations’.

This article is for informational purposes only and should not be relied upon as tax or legal advice. Please consult professionals for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.