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Oct 2006
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October 01, 2006

New Code Section 409A: Some Surprises for Colleges and Universities

New Tax Code section 409A is a law affecting “deferred compensation plans.” Enacted in response to perceived abuses by Enron officials, 409A imposes strict requirements on how employers and employees may defer income and severely limits the ability to accelerate or redefer payments. Failure to comply with Section 409A's requirements will result in harsh penalties on the individual employee that include early taxation of deferred income, a 20% additional penalty tax, and interest at the late payment interest rate plus 1%.

Section 409A defines a “deferred compensation plan” as any arrangement under which an amount is earned in one year or multiple years and paid in a later taxable year. While qualified retirement plans are exempt, the definition is broad enough to include severance plans and arrangements given not only to top officials, but ordinary employees as well. A “plan” is any written or unwritten plan, employment contract, board resolution, policy or practice that provides deferred compensation for one or more individuals. Employers of all sizes, taxable and tax-exempt, private, public or governmental, must comply.

A common source of trouble for colleges and universities will be severance arrangements. A severance arrangement that pays all benefits in one lump sum shortly after termination or falls within an exception for involuntary severances that pay all benefits by the end of the second calendar year following termination will generally not be subject to 409A. All other severance arrangements will likely have to conform to Section 409A. And even the two-year exception will not apply if the severance arrangement also includes a continuation of health or other benefits unless all of these benefits are also paid by the end of the second calendar year following termination, including payment of all medical clams submitted to the health plan!

Here are some examples of problems that may arise under 409A:

The Fired coach. Big-City University is disappointed with its current basketball coach. The coach is in the middle of the third year of a guaranteed six-year contract, but each year the team has done worse, and this season is looking like a disaster. The university decides to terminate the coach, even though it will require the university to continue paying salary and benefits over the remaining 3+ years of the contract. In order to get out of this obligation sooner, the University would like to negotiate a lump-sum payment.

This arrangement raises a number of 409A problems. The guaranteed payments following termination constitute deferred income under 409A. Moreover, unless the acceleration was built into the initial agreement, the payments cannot be accelerated and paid in a lump sum without invoking 409A penalties. Even if the arrangement is kept in place as is, the coach also has a potential 409A problem with his health plan continuation benefit, as this may end up being a “discriminatory” benefit. Under either scenario, the coach could face harsh penalties under 409A.

The University President’s Stay Bonus. When Mid-Town University hired its current president, it negotiated an employment agreement that included a generous “stay” bonus that would be paid if she were still president on the 5th anniversary of her hiring. Currently in the middle of the fourth year, the president has recently approached the University and has asked if the bonus can instead be paid out over a five year period in equal annual payments beginning at the end of the 5th year.

As part of its regulation of deferred income, 409A severely restricts the ability to redefer income. Any redeferral election cannot take effect for at least twelve months, and (with certain limited exceptions) must be deferred for at least five years. If the University grants the president’s request, she would face stiff penalties.

12-Month Pay Arrangements. Many of Small-Town University’s professors and staff work only nine months of the year but have elected to have their salaries paid over a twelve-month time period. Thus, every paycheck earned between the beginning of September and the end of May is reduced for salary payments that are made in June, July and August. Under 409A, these employees have agreed to defer income earned in one year (September through December) for payment in the next calendar year, which makes these payments potentially subject to 409A!

We hope the IRS will address this surprising and unnecessary result in upcoming regulations. This is definitely not the type of situation Congress had in mind in enacting 409A.

As these examples illustrate, new Code Section 409A has some surprising consequences for colleges and universities. Fortunately, the regulations do provide for a limited transition time period when existing arrangements can be reworked. Colleges and universities should have experienced counsel review existing employment and severance arrangements, as well as any executive compensation arrangements and bonus arrangements, for compliance with 409A. Going forward, all new such arrangements should also be carefully structured to comply with or—when possible—avoid 409A.
 

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