Executive Compensation Update: Just the Facts (and Circumstances) Please—Substituting One Compensation Form for Another

In one sense, a dollar is fungible—you can replace one with another, without the person who receives that dollar worrying much about the exchange. However, for income tax purposes, dollars paid as compensation for services often need to be identified and labeled in a way that allows tax law conditions, limitations and treatments to properly attach to the appropriate items of compensation. Proper identification and labeling often depends on the "facts and circumstances," and can be a complicated, sometimes frustrating exercise, with a lot at stake both for the company and the person being compensated.

The Internal Revenue Service is concerned that, because a dollar is fungible, an employer and employee may seek to mitigate a tax law condition or limitation associated with a given item of compensation by agreeing that if that condition or limitation becomes applicable, a different item of compensation will be paid. This article discusses areas of recent IRS focus where it is necessary to consider the "facts and circumstances" to determine whether one item of compensation is really a substitute for another that cannot be paid, or that would have unfavorable tax consequences, because of a tax law condition or limitation.

Substitutions to Avoid Performance Conditions Under Code Section 162(m)

"Performance-based compensation" is exempt from the $1 million deduction limit of Section 162(m) of the Internal Revenue Code. Compensation is not considered performance based for purposes of Section 162(m) if "the facts and circumstances indicate that the employee would receive all or part of the compensation regardless of whether the performance goals are attained." This determination is made by taking into account all plans, arrangements and agreements that provide for compensation to the employee.

As an example, if an employer maintains two bonus plans—one that pays a bonus only if performance goals are met and another that pays the same bonus even if goals are not met—when the two programs are considered in combination, the "facts and circumstances" clearly indicate that the arrangement is not performance based, and thus will count towards the $1 million annual limit on deductible compensation.

That is not to say that a compliant performance-based bonus arrangement cannot coexist with another bonus arrangement. However, in that case, it is important to be mindful of (and avoid) the "facts and circumstances" that could cause the IRS to view the non-performance-based bonus (or any other element of compensation) as having negated the performance-based condition of the Section 162(m) arrangement. For example, an express policy stating that no employee has a guaranteed right to any discretionary bonus as a substitute for a performance bonus if performance targets are not met may be helpful to a facts-and-circumstances test. In a private letter ruling dated January 18, 2006, the IRS told an employer that had included such a policy in its proxy statement that a "reservation of the right to pay discretionary bonuses outside of the [company's] Bonus Plan will not prevent the Bonus Plan from qualifying as a qualified performance-based compensation plan . . . ." Even careful documentation is not enough, however, if in operation discretionary bonuses are awarded to compensate for lost performance-based bonuses: "The question of whether, in operation, the payment of discretionary bonuses causes the performance based compensation to be paid other than solely on account of the attainment of one or more pre-established, objective performance goals is a question of fact," the IRS added.

The IRS generally will not opine on facts-and-circumstances determinations, and has indicated in other rulings that such questions "are best resolved…upon examination of several or more filed income tax returns."

This "substitution" concern is illustrated in another IRS letter from September 2007. In that ruling, a payment made under an employment agreement in the event of an involuntary termination (other than for cause), or in the event of a termination for "good reason," was considered a substitute for what was otherwise a performance-based bonus under Section 162(m). Because the "facts and circumstances" of the individual's compensation package (the employment agreement coupled with the incentive plan) indicated that a payment would be provided under circumstances not permitted by Section 162(m), the incentive plan failed with respect to that individual.

The facts and circumstances of a discretionary payment will ultimately determine whether or not the IRS labels that payment as a substitute for performance-based compensation. Now comes the source of many an employer's—and lawyer's—frustration: creating the appropriate facts and circumstances when the IRS has generally declined to comment on what those facts and circumstances should be. It is fair to expect at this point that there is no "safe-harbor" employment or severance agreement design that is guaranteed to prevent a severance payment that is measured by reference to a performance-bonus from being cast as a spoiler to a performance-based incentive plan under Section 162(m). However, the many facts and circumstances should be considered and controlled in a way to present the best argument that a severance payment is not a substitute for a forfeited performance-based award. In this regard, helpful facts and circumstances may include:

• Defining the severance payment strictly as a multiple of base pay (with no bonus reference), or by reference to a historical measure of bonus;
• If severance is provided to a broader group (e.g., under a severance plan), defining the severance by reference to a measure that is applicable to everyone, even those who are not entitled to the bonus (e.g., W-2 pay, with appropriate carve-outs for items not included in severance calculations, such as option exercise amounts);
• Evaluation and retention of data that the severance benefit being provided in its totality is consistent with industry standards; or
• Implementation of the severance arrangement early (e.g., as part of an employment agreement), rather than shortly before it is triggered.

Even with the best-designed severance plan, however, facts and circumstances may still be problematic. The best of designs may not overcome a letter from the executive specifying his desire to have a severance payment to compensate for the lost opportunity to earn a performance bonus in the year of a severance.

Substitutions to Avoid Distributions Rules Under Section 409A

This issue of fungibility—whether one dollar of compensation can be substituted for another without consequences—also arises with nonqualified deferred compensation paid under Internal Revenue Code Section 409A. Within the meaning of Section 409A, "nonqualified deferred compensation" is subject to stringent rules regarding the timing of payment, and changes to the timing of payment, of deferred compensation. Accelerating the payment date can result in a violation of Section 409A, with significant negative tax consequences to the individual.

Under Section 409A, the payment of an amount as a substitute for a payment of deferred compensation will be treated as a payment of deferred compensation, which in turn may be viewed as an impermissible acceleration, with different tax consequences. For example, if in connection with a separation from service, an employee enters into a separation agreement where he relinquishes a right to an amount payable in the future in exchange for a current payment of the present value of such future deferred compensation payment, the right to the current payment is viewed as a substitute for, and thus an impermissible acceleration of, the original deferred compensation payment. The same is true if a payment is made to compensate an employee for amounts forfeited under a deferred compensation plan.

And if a payment is deemed to be an impermissible acceleration, some unpleasant consequences will follow: The employee will owe tax on the compensation back to the date it was originally deferred, plus interest and penalties on that amount; and any amounts deferred under plans that, under Section 409A rules, fall into the same category as the plan under which the forfeited deferred compensation benefit was paid will be subject to current taxation, interest and penalties.

As under Section 162(m), it is critical to avoid the identification of a payment as a "substitute" for a deferred compensation payment. Likewise, whether a current payment acts as a substitute for a forfeited or relinquished deferred compensation right is to be determined "based on all the facts and circumstances."

With Section 409A, though, the IRS goes a bit farther, providing that "the payment of an amount or creation of a new right to a payment proximate to the purported forfeiture or voluntary relinquishment of a right to deferred compensation is presumed to be a substitute for the deferred compensation." Thus, the timing of actions is one of the facts and circumstances to be particularly mindful of under 409A. This presumption can be rebutted, however, by showing that the new compensation would have been received regardless of the forfeiture or relinquishment. Relevant factors considered by the IRS include:

• If the amount paid is materially less than the forfeited or relinquished amount, or
• If the amount paid consists of a type of payment customarily made in the ordinary course of business to persons who do not forfeit or relinquish the right to deferred compensation (e.g., payment for a release of claims against the employer).

Careful consideration and documentation of the facts and circumstances thus is again critical to rebutting a challenge that a payment is in fact a substitution for, and impermissible acceleration of, a deferred compensation amount.

Substitutions to Qualify for Separation Pay Status Under Section 409A

Section 409A provides special rules and exemptions for payments made under a "separation pay plan," and status as a separation pay plan can be helpful under Section 409A. Further, separation pay plans that pay only upon involuntary separation are viewed as a separate category of plans under Section 409A, thus limiting the potential consequences of Section 409A if a violation occurs. Should an arrangement be deemed non-compliant, the individual would owe tax, interest and penalties not only on the amounts paid under the non-compliant arrangement, but on any amounts deferred under any other arrangement of the same type, with which the non-compliant plan is aggregated under IRS rules. Therefore, it is desirable to limit the number of plans of the same category or type, as a violation under one plan subjects all similar plans to current taxation, interest and penalties.

A separation pay plan generally is a plan or agreement that provides for payments conditioned upon a separation from service with the employer—think of it as a severance-type arrangement (although the concept is broader). A separation pay plan that provides payments only in the event of an involuntary separation from service and appropriately limits the payment amount and period of payment escapes deferred compensation status under Section 409A under a separation pay "safe harbor."

But the concern with substitutions also extends to separation pay plans. Section 409A regulations provide that any payment made under a separation pay plan that substitutes for or replaces an amount forfeited or relinquished under another deferred compensation arrangement is treated as a payment under the deferred compensation arrangement and not as a payment under the separation pay plan. Such amounts thus would not qualify for the safe harbor, and may constitute an acceleration of the deferred compensation payments in violation of Section 409A, with serious consequences.

Once again, whether a substitution has occurred is to be determined under the "facts and circumstances," with a presumption that there was a substitution if the separation pay plan provides for the payment upon a voluntary termination of employment. The presumption can be rebutted if:

• the amount paid is materially less than the present value of the forfeited or relinquished amount multiplied by a fraction, the numerator of which is the period of service actually completed by the participant and the denominator of which is the period required for full vesting, or
• the amount paid consists of a type of payment customarily made in the ordinary course of business to persons who do not forfeit or relinquish a deferred payment (e.g., payment for a release of claims).

Again, attention to the facts and circumstances is vital.