The Advisors' Blog

– Laura Thatcher, Alston & Bird LLP

Blogging has proved to be both a novel and rewarding exercise! Since my blog a few weeks back about whether it is too late to change a good reason definition, I have received several thoughtful responses – which just goes to emphasize my point that Section 409A is way too complicated in the fringe areas of deferred compensation.

One commenter suggested that I am perhaps being too liberal in concluding that a “deficient” good reason definition can be reformed in 2008 for purposes of the two-times/two-year exemption. (I hold my ground on that one, based on Notice 2007-78, last paragraph of Part IV.A.)

In the other direction, Max Schwartz of Sullivan & Cromwell chimed in with an interesting dialog suggesting that I am being overly conservative in concluding that it is too late to reform a “deficient” good reason definition in 2008 for purposes of the short term deferral exemption. At the risk of paraphrasing his point, let me paraphrase his point:

Notice 2007-78, Part IV.A, sixth paragraph says:

The Treasury Department and the IRS understand that taxpayers may desire to conform existing good reason conditions to the requirements of the definition of an involuntary separation from service under the regulations. Accordingly, to the extent that a right to a payment subject to an existing good reason condition is subject to a substantial risk of forfeiture, the modification of the good reason condition on or before December 31, 2008 to conform to some or all of the conditions set forth in § 1.409A-1(n)(2) will not be treated as an extension of the substantial risk of forfeiture. However, if the right to a payment subject to existing good reason conditions is not subject to a substantial risk of forfeiture, the modification of such condition to include one or more of the conditions set forth in § 1.409A-1(n)(2)(ii), or to remove one or more of the existing good reason conditions, will not cause the amount to be treated as subject to a substantial risk of forfeiture.

Max correctly notes that this paragraph of the Notice keys the ability to reform the good reason definition on whether the right to payment is “subject to a substantial risk of forfeiture” – not on whether the good reason condition is tantamount to an “involuntary termination” condition under Section 409A. He also points out that the final regulations (§1.409A-1(d)(1)) say that if a right to payment is conditioned on “involuntary termination” it will be subject to a “substantial risk of forfeiture” — but do not say the converse – i.e., that if a right to payment is not conditioned on involuntary termination it is not subject to a substantial risk of forfeiture (because there other ways to be subject to a substantial risk of forfeiture).

Given that these are two distinct standards (with involuntary termination being a subset of substantial risk of forfeiture), he concludes that as long as the right to payment is still subject to a substantial risk of forfeiture, you can fix at will (for the rest of 2008).

To illustrate the point, let’s take an absurd example of a good reason definition triggered solely by the company requiring the CEO to park in a different parking space (an example often used by IRS speakers in conference settings as being a good reason definition that is way off the safe-harbor mark and definitely not tantamount to “involuntary termination”). To earn the severance payment the CEO has to continue to perform services until the company actually requires him to park elsewhere.

That action is not within the control of the CEO (one assumes) and the company would not take that action until it was prepared to terminate the CEO (because the company knows that moving the parking spot would trigger the right to severance). If the company has not yet taken that action, is the severance payment still subject to a substantial risk of forfeiture? One could argue that it is. If so, then Notice 2007-78, Part IV.A would not preclude the parties from changing to the safe-harbor good reason definition in 2008 and thereby salvage the short-term deferral exemption for a termination of employment occurring in 2009 or later. I had never thought of it that way.

Moving to a more realistic example: a good reason definition that is close to the safe-harbor but is missing on a few cylinders, such as one that triggers on any reduction in compensation, without a materiality qualifier, or that has no cure period. It is much easier to conclude that the right to payment under that definition is “subject to a substantial risk of forfeiture” even if it does not chin to the bar of “involuntary termination” (which is a closer call). The further removed you get from the safe-harbor good reason definition, the closer the call on the involuntary termination analogy.

Whether a particular hair trigger is a good “substantial risk of forfeiture” depends on the facts. Max’s view would be that if it’s in the control of the employer and not the employee, then it may well be a under a substantial risk of forfeiture until the employer decides to take the action. For example, a trigger based on the employee getting his feelings hurt would not suffice.

I am inclined to agree with Max that, given the right facts, there is still time to reform a “bad” good reason definition in 2008 to avail the short-term deferral exemption. Let me hear from you if you have other views on the subject. This is great forum for sharing timely advice before the final curtain falls.