Gimme 5: What Every Lawyer Should Know about 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.
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:
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.
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).