June/July 2008 • Vol. 28 No. 6 | An E-Publication of the Los Angeles County Bar Association

Gimme 5: What Every Lawyer Should Know about Drafting and Negotiating Executive Employment Agreements

By Stephen H. Harris, a partner in Paul, Hastings, Janofsky & Walker LLP’s Los Angeles office, who practices employment and employee benefits law, and Frances M. Nicastro, an associate in the firm’s New York office, who also practices employment and employee benefits law. They can be reached at StephenHarris@paulhastings.com and francesnicastro@paulhastings.com, respectively. This article is provided for informational purposes only and does not constitute legal advice.

Here are five important tax issues for practitioners to consider when drafting and negotiating executive employment agreements.

1. Non-qualified deferred compensation. Corporate scandals and the public perception that executives often receive deferred compensation distributions shortly before bankruptcy proceedings contributed to Congress’ decision to enact Internal Revenue Code Section 409A. Section 409A requires non-qualified deferred compensation to meet complex requirements to avoid immediate taxation, the imposition of a 20 percent additional tax, and other penalties (including, in some states, a parallel tax detriment). Although Section 409A aims to prevent tax abuse, its broad reach impacts many non-tax motivated arrangements. Section 409A’s extremely detailed and complicated nature is reflected in its more than 200 pages of regulations.

Unless there is a special exception (e.g., for payments that are made shortly after the lapse of a substantial risk of forfeiture), Section 409A generally applies any time an agreement provides an employee with a legally binding right to receive payment of compensation in a future tax year. (These types of payments often are found in employment, severance, change in control, and incentive compensation plans or agreements.) Although most arrangements can be structured to comply with Section 409A, practitioners need to be especially cautious when drafting any arrangement that provides an employee with deferred compensation because of the significant tax detriments to noncompliance. 

Practice Pointers:

  • Options to purchase common stock of the employer (or its parent company) generally are exempt from Section 409A. Section 409A, however, normally does apply to discounted stock options (those with a strike price less than fair market value). Therefore, avoid discounted stock options unless the stock option grant is carefully drafted to avoid 409A problems.
  • Several Section 409A exceptions potentially apply to separation payments made on account of an involuntary termination of employment, which can include “good reason” resignations. Ensure that any good reason definition complies with Section 409A’s safe harbor or that the payment is structured to otherwise comply with Section 409A. 

2. Golden parachutes. Whenever an employment agreement provides for special payments to executives in connection with corporate changes in control (whether or not in conjunction with a termination of employment), Internal Revenue Code Sections 280G and 4999 (the “Golden Parachute Rules”) might apply.

The Golden Parachute Rules generally apply when a specified executive receives payments that are contingent on a change in control that equal or exceed three times the executive’s base amount (generally determined based on taxable income during the prior five years). If so, the employer will lose its deduction for the golden parachute payments (all amounts above one times the executive’s base amount), and the executive will incur a 20 percent excise tax on the parachute payments. 

Although there are a number of exceptions (for example, when a taxpayer is able to establish by clear and convincing evidence that the payment, even if in excess of the three times multiplier, is reasonable compensation for post-change-in-control services), it is imprudent to assume that one will apply. Most executive employment agreements that are carefully thought-out:

  • Provide for an automatic cutback so that the executive receives slightly less than three times his or her base amount (thus ensuring that golden parachute penalties are not triggered),
  • Provide for a modified automatic cutback so that the executive receives slightly less than three times the base amount, unless the executive would receive more compensation without the cutback, after paying income and excise taxes (maximizing the net payment to the executive but still subjecting the employer to a potential loss of deduction), or
  • Provide for a gross-up on the excise taxes on the parachute payment (and on the income and excise taxes on the gross-up) so that the executive nets the same amount he or she would have, absent application of the Golden Parachute Rules. (This is becoming increasingly less common and is the most expensive alternative for the employer.)

3. The Million Dollar Club. Practitioners who negotiate employment agreements for covered executives at publicly traded companies (those who will be working as a principal executive officer or whose total compensation must be reported to shareholders under the Securities Exchange Act of 1934, usually the three highest compensated officers for that year other than the principal executive or financial officer) need to consider Section 162(m). Section 162(m), when it applies, typically prohibits employers from deducting more than $1 million of the covered executive’s compensation. The $1 million deduction cap is subject to a number of exceptions, including a widely used exception for “performance based compensation,” i.e., generally, compensation payable solely on account of the attainment of preestablished, objective, and shareholder-approved performance goals determined by a compensation committee consisting solely of two or more outside directors computed under an objective formula.

Practice pointers:

  • Don’t blindly renew existing compensation arrangements. Many such arrangements provide that the executive will receive payment of performance-based compensation if the executive is terminated without cause, quits for good reason, or retires. The IRS recently stated that these types of payment provisions will preclude the compensation from being exempt from the $1 million dollar limit—even if the compensation ultimately is paid on account of performance goal attainment—because the compensation could have been paid on account of a non-performance-based reason (e.g., a good reason resignation). 
  • One common method for ensuring that a deduction is not lost under Section 162(m) is to provide that payment that otherwise would be non-deductible will be paid in the first calendar year in which the payment can be made and deducted, e.g., following termination of employment.

4. Reimbursement pitfalls. Club dues, cars, and even vacation travel are commonly reimbursed items. Many executives and companies assume that these types of reimbursements will be tax-free to the executive. Understanding the tax consequences to these payments is important to proper drafting. These items are almost never tax-free.

5. When to pay the piper. It is fairly common for employers to grant restricted company ownership interests to their executives (for example, restricted stock), usually vesting over a three-to-five-year period of service. Under general tax rules, the executive would be taxed as the property vests. It is important to understand that an employee who receives restricted property may be able to make a special election under Internal Revenue Code Section 83(b). Making the election has two important consequences. First, the employee must include in income the value of the property less the amount he or she paid for it. Second, any additional increase in value will be taxed at long-term capital rates when the employee disposes of the property (assuming the holding period is met). 

Practice Pointer:

  • An employee only has 30 days to notify the Internal Revenue Service of a Section 83(b) election following receipt of the property.

 




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