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This article answers questions about incentive plan considerations and nonqualified deferred compensation issues arising from the economic downturn due to the novel coronavirus (COVID-19) pandemic. The massive market shake-up and economic upheaval triggered by the COVID-19 crisis echoes the sudden massive economic crisis that hit in the fall and winter of 2008. In the first quarter of 2009, many companies, still stinging from a crashing market, faced significant challenges in designing and operating their executive compensation programs. Many had to address the immense challenge of designing meaningful and appropriate annual and long-term incentive plans at a time of extreme economic uncertainty. Depressed stock values created problems for equity compensation plans. Much of what we experienced during the 2008/2009 economic crisis can inform our actions now.
Can or should companies make adjustments to their annual and long-term incentive plans in light of COVID-19 business impacts?
As in 2008/2009, many companies now face the challenge of designing meaningful and appropriate annual and long-term incentive plans, programs and agreements at a time of extreme economic uncertainty. This time, though, the crisis is emerging during the first quarter, when many incentive plans (for companies with calendar year fiscal years) have just been designed or are in the process of being finalized. Companies may want to consider the following actions and issues in designing and implementing their 2020 annual and long-term incentive plans:
We were about to pay our 2019 annual bonuses but want to indefinitely delay payment given financial uncertainty caused by COVID-19. Will that delay cause any legal issues?
Companies with a calendar year fiscal year often pay annual bonuses during the first quarter of the following year (usually before March 15th). Some of those companies that have not yet paid their 2019 annual bonuses may be considering a delay in payment as a means to conserve cash in the uncertain short-term or in order to shift cash payments to other employee priorities like paid leave. Companies should carefully consider a number of potential legal issues before delaying bonus payments:
What does the bonus plan say as to timing of payment? A delay in payment beyond the time permitted by the plan could lead to employee breach of contract claims (in additional to employee relations’ issues). Where necessary, companies should seek the consent of adversely affected employees to alter the terms of the award or agreement.
State Wage and Hour Laws
Which state wage and hour laws apply? Some state laws have minimum time periods in which bonus payments must be made.
Section 409A Compliance
Will a payment delay cause the plan to violate Section 409A? Bonus plans need to be designed either to be exempt from, or comply with, Section 409A. A bonus plan that is subject to, but fails to comply with, Section 409A can trigger significant adverse tax consequences for the employees, including a 20% tax in addition to normal income taxes (and potentially additional state taxes).
Plans Designed to Be Exempt
Bonus plans are often designed to be exempt from 409A, usually under the short-term deferral exception. Plans may satisfy this exception by paying the bonus no later than two and one-half months after the end of the year in which the right to the payment becomes vested. Plans also may satisfy this exemption by requiring employment through the bonus payment date in order for the bonus to be considered earned and vested.
If the company delays payment, and the employee must be employed on the date of payment to earn the bonus, the company will need to consider if it will require continued employment through the delayed payment date to receive the bonus (and whether it can enforce such a requirement). If the continued employment requirement cannot be enforced, the company will want to ensure that payment is made no later than March 15, 2021 (the end of the short-term deferral period for compensation that first vests in 2020).
On the other hand, if the employee is vested in the bonus as of the end of the prior year, and the company has not already paid the bonus, there will be Section 409A concerns, and the company will need to consider corrective measures.
Plans Designed to Be Compliant
If the bonus was designed to be compliant with Section 409A by, for example, specifying the date of payment for the first quarter of 2020, then, Section 409A permits payment of the bonus as late as December 31, 2020 (although, as noted above, there may then be contractual and employee relations issues to address).
Special Rules for Late Payments
It may also be possible to invoke special rules under Section 409A that allows delayed payments (beyond the short-term deferral period or beyond the payment period under the plan)—for so long as the payment might reasonably threaten the ability of the company to continue as a going concern—but the IRS views this special rule as a narrow one. Other approaches for managing compliance with Section 409A may also be available.
Because the Section 409A rules are very complex and can trigger significant adverse tax results for employers and employees, these rules should be closely reviewed before a decision to delay payment is made.
The COVID-19 crisis has caused our stock price to drop dramatically. What impacts could this have on our equity compensation program?
Lower stock prices can have potentially significant impacts on equity plans and outstanding equity awards:
Can we permit participants to cancel deferral elections and/or receive distributions from our nonqualified deferred
Generally, once the deadline for making the deferral election under a Section 409A plan has passed, the election becomes irrevocable. Any subsequent revocation or cancellation of the election would result in a violation of Section 409A and adverse tax consequences. However, the participant’s deferral election may be canceled where the participant experiences an unforeseeable emergency under 409A or takes a hardship distribution from the company’s 401(k) plan. In that event, the deferral election must be cancelled in full (not merely postponed or delayed). Any deferral election made after the cancellation will be subject to the normal provisions governing deferral elections for the period in question (no evergreen rules can apply).
In addition to cancellation of the participant’s deferral election, the participant may be permitted to receive distributions from the participant’s account under the deferred compensation plan upon an unforeseeable emergency. Whether the participant is faced with an unforeseeable emergency permitting distributions under Section 409A (and/or cancellation of a deferral election) is based on the facts and circumstances.
For an event to constitute an unforeseeable emergency, the event must arise from extraordinary and unforeseeable circumstances beyond the control of the participant and cause the participant a severe financial hardship. A hardship will constitute a severe financial hardship under Section 409A only if it cannot be relieved through compensation or reimbursement received from insurance or otherwise, by liquidation of the participant’s other assets (to the extent such liquidation does not itself cause a severe financial hardship), or by ceasing future deferrals of compensation under the plan.
Specific extraordinary and unforeseeable circumstances or events that could trigger an unforeseeable emergency include the following:
Unlike a hardship distribution from a 401(k) plan, an unforeseeable emergency under Section 409A does not include payment of tuition and related expenses of post-secondary education for the participant or his or her spouse, children or dependents.
The amount of deferred compensation that can be distributed upon a qualifying unforeseeable emergency must be limited to the amount reasonably necessary to satisfy the emergency need (which may include any amounts necessary to pay any income taxes or penalties reasonably anticipated to result from the distribution). In determining the amount necessary to satisfy the emergency need, the employer must consider the additional compensation that the participant could obtain by canceling future deferral elections under all qualified and nonqualified deferred compensation plans. The employer is not required to consider any available distribution or loan from a qualified plan or from another nonqualified deferred compensation plan.
Whether an employee has experienced an unforeseeable emergency under Section 409A depends on the specific facts and circumstances. Not all hardships created by the COVID-19 crisis will necessarily rise to this level. Companies with unforeseeable emergency provisions in their Section 409A deferred compensation plans will want to establish a reasonable, documented administrative process to make unforeseeable emergency determinations on any specific set of facts. If the company’s plan does not currently provide for distributions upon an unforeseeable emergency, that provision can be added at any time.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.