A Primer On The Impact of The New Economic Stimulus Laws and IRC 409A On Executive Compensation in Mergers and Acquisitions

A Primer on the Impact of the New Economic
Stimulus Laws and §409A on Executive
Compensation in Mergers and Acquistions

Paul E. Starkman
A R NS T EI N & L E H R LLP
120 S O UT H R I V E RS I D E P LA ZA | S UIT E 1200
C H I C A G O , I L 6 06 06

P 3 12 . 8 76 . 789 0 | F 3 12 . 8 76 . 02 8 8
pestarkman@arnstein.com

A B O UT P A UL E. ST A R KM A N
Paul E. Starkman
Paul E. Starkman is the Chair of the Labor & Employment Law Practice Group at
Arnstein & Lehr LLP in Chicago, Illinois. He assists clients who are employers and
executives on a broad range of corporate transactions, executive compensation and
employee benefit issues, and employment-related litigation.
He is a fellow of the College of Labor and Employment and a co-chair of the

Contingent Worker Sub-committee of ABA Employment Rights & Responsibilities
Committee. Mr. Starkman frequently speaks on employment issues at conferences
throughout the country and has been published extensively. Most recently, he is a
principal author of Employment Arbitration: Law and Practice (West/Thomson 2007-
2008).
Paul E. Starkman
Arnstein & Lehr LLP
120 South Riverside Plaza
Suite 1200
Chicago, Illinois 60606
(312) 876-7890
(312) 343-1220 (Cell)
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P A UL E . S TA R KMA N | A P R IM E R O N T H E I M PA C T O F TH E NE W E C O N O MI C S T IM ULUS LA WS
I. The New Economic Stimulus Laws: The American Recovery and

Reinvestment Act of 2009 ("ARRA"), the Emergency Economic Stabilization
Act of 2008 ("EESA"), and the Troubled Assets Relief Program ("TARP")
A. Introduction
i. On February 17, 2009, the American Recovery and Reinvestment

Act of 2009 ("ARRA") or the Economic Stimulus Bill became law
and expanded the executive compensation requirements
previously imposed under the Emergency Economic
Stabilization Act of 2008 ("EESA") and the Troubled Assets Relief
Program ("TARP"). ARRA's executive compensation restrictions
apply to any entity that has received or will receive financial
assistance under TARP (a "TARP Recipient") and generally will
continue to apply for as long as any TARP financial assistance
obligation remains outstanding, other than government-held
warrants (the "TARP Assistance Period"). The ARRA restrictions
are not limited to recipients of the TARP Capital Purchase
Program, but rather they potentially apply to anyone
participating in any TARP program or the Financial Stability Plan
announced on February 10, 2009, unless participation is solely
connected to loan modification programs under Section 109 of
EESA.
ii. ARRA imposes a more comprehensive set of executive

compensation restrictions on all TARP Recipients that depend on
the nature of the assistance received by a TARP Recipient. The
ARRA rules are a combination of some of EESA's prior executive
compensation rules, prior Treasury guidance, and a number of
the proposed executive compensation guidelines announced by
the Treasury Department on February 4, 2009 (the "Treasury
Guidelines"). ARRA left in place EESA's tax deductibility and
excise tax provisions, but the $500,000 annual compensation
limit under the Treasury Guidelines for certain TARP Recipients
was not included in ARRA.
B. ARRA’s General Standards. ARRA requires TARP Recipients to meet the

following executive compensation and corporate governance standards
during the TARP Assistance Period:
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i. Any compensation plan that encourages any senior executive

officer to take unnecessary and excessive risks that threaten the
value of the institution, or that encourages the manipulation of
reported earnings, is prohibited.
ii. A claw-back provision allowing the TARP Recipient to recover any

bonus, retention award, or incentive compensation paid to a
“senior executive officer” and any of its next 20 most highly
compensated employees based on statements of earnings,
revenues, gains, or other criteria that are later found to be
materially inaccurate.
iii. A TARP Recipient's "senior executive officers" are its five most
highly paid executives whose compensation is required to be
disclosed pursuant to the Securities Exchange Act of 1934 (the
"Exchange Act") and its regulations (or, for nonpublic companies,
comparable employees).
iv. During the TARP obligation period, golden parachute payments

(defined as any payment to a person who departs a company for
any reason, except payment for services performed or benefits
accrued) are prohibited to any senior executive officer and the
next five most highly compensated employees, regardless of the
amount of TARP assistance received.
v. ARRA prohibits any compensation plan that would encourage

manipulation of the reported earnings of the TARP Recipient to
enhance the compensation of any of its employees.
C. Prohibition Against Accrual of Certain Bonus, Retention Award, and

Incentive Compensation
i. During the TARP Assistance Period, TARP Recipients are

prohibited from paying or accruing any bonus, retention award,
or incentive compensation, other than the payment or accrual of
long-term restricted stock that:
a. does not fully vest during the TARP Assistance Period; and
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b. has a value not greater than one-third of the total

amount of annual compensation of the employee
receiving the stock.
ii. The ARRA prohibition against the payment or accrual of bonus,

retention awards or incentive compensation applies to different
employees of TARP Recipients depending on the amount of
financial assistance they receive under TARP:
a. If the financial institution received less than $25 million in

financial assistance, only the most highly compensated
employee of the institution is subject to the ARRA
restrictions.
b. If the financial institution received at least $25 million but

less than $250 million in financial assistance, at least the
five most highly compensated employees of the
institution are covered.
c. If the financial institution received at least $250 million

but less than $500 million in financial assistance, the
senior executive officers and at least the next 10 most
highly compensated employees are subject to the
restrictions.
d. If the financial institution received $500 million or more in

financial assistance, the senior executive officers and at
least the next 20 most highly compensated employees of
the institution are subject to the ARRA restrictions.
iii. The Treasury Department can decide to apply the ARRA

restrictions to a greater number of employees. In the case of all
TARP Recipients, ARRA does not prohibit any bonus payment
required to be paid pursuant to a written employment contract
executed on or before February 11, 2009.
D. Board Compensation Committee
If they have not already done so, TARP Recipients must establish a Board
Compensation Committee that is composed entirely of independent directors; and
meets at least semiannually to evaluate the risks posed by employee compensation
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plans to the TARP Recipient. However, if the TARP Recipient's common or preferred
stock is not registered and it has received $25 million or less in financial assistance
under TARP, these responsibilities are to be carried out by the TARP Recipient's board
of directors.
E. Luxury Expenditures Limitation Policy
Each TARP Recipient's board of directors must implement a company-wide policy on

excessive or luxury expenditures that may relate to:
• entertainment or events;
• office and facility renovations;
• aviation or other transportation services; or
• other activities or events that are not reasonable expenditures

for staff development, reasonable performance incentives, or
other similar measures conducted in the TARP Recipient's
normal course of business operations.
F. Nonbinding Shareholder “Say on Pay” Votes on Executive

Compensation
Each TARP Recipient must permit a separate shareholder vote to approve the TARP
Recipient's executive compensation at any annual or other meeting of its shareholders
during the TARP Assistance Period, but the vote will not be binding on or overrule any
decisions by the TARP Recipient's board of directors, does not create any additional
fiduciary duty on the part of the board, and will not restrict the TARP Recipient's
shareholders from making proposals in proxy materials related to executive
compensation.
G. Treasury Department’s Review of Prior Payments to Executives
The Treasury Department is to review bonuses, retention awards, and other

compensation paid to the senior executive officers and the next 20 most highly
compensated employees of each entity receiving TARP assistance before the date of
enactment of ARRA to determine whether any such payments were inconsistent with
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the purposes of the revised executive compensation requirements or TARP, or were

otherwise contrary to the public interest. If the Treasury Department makes such a
determination, it is directed to seek to negotiate with the TARP Recipient and the
subject employee for appropriate reimbursements to the federal government with
respect to compensation or bonuses.
H. Certification of Compliance with ARRA’s Executive Compensation

Requirements
As under the Sarbanes-Oxley Act, each TARP Recipient's chief executive officer and
chief financial officer (or their equivalents) is required to provide a written certification
of the TARP Recipient's compliance with ARRA’s executive compensation
requirements to the SEC in its annual filings (or, in the case of a nonpublicly traded
company, to the Treasury Secretary).
I. Section 162(m)
Each TARP Recipient is subject to the $500,000 compensation deduction limitation of

Internal Revenue Code Section 162(m)(5). Because this Code provision is premised on
government acquisitions of assets rather than government stock purchases, it is not
clear how it will apply, if at all, to TARP Recipients.
J. Post-ARRA Developments
On March 19, 2009, the United States House of Representatives voted 328-93 to
approve H.R. 1586, a bill that will retroactively impose a 90 percent tax on executive
bonuses paid after December 31, 2008 by companies that have received over $5
billion in Troubled Asset Relief Program (“TARP”) funds (i.e., AIG, Citigroup and 9 other
large institutions).
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II. The Impact of §409A on Executive Compensation in Pre- and Post-

Acquisition Settings
A. How Does §409A Affect Mergers and Acquisitions?
i. Enacted in 2004, §409A of the Internal Revenue Code may be the

most significant development affecting executive compensation
since the passage of ERISA, especially in pre- and post-
acquisition settings.
ii. Because the penalties for failing to comply with §409A’s rules on
defined compensation arrangements are so onerous (see
Section II(C) below), the parties to mergers and acquisitions must
be extremely careful about §409A compliance, not only in pre-
acquisition stage, but also in the drafting of the acquisition
agreement and in the post-acquisition setting. The failure to
exercise proper due diligence may cause the parties to lose some
of the benefits of the transaction due to unanticipated §409A
liabilities and may increase the cost of acquiring (or divesting) a
public or private company.
iii. In the pre-acquisition setting, sellers often try to make their

companies more attractive to buyers by accelerating, pushing
back or eliminating the payment of deferred compensation to
employees – which can have significant §409A effects. Likewise,
in a post-acquisition, some buyers may want to re-negotiate or
terminate deferred compensation arrangements in order to align
management with the new owners and eliminate vestiges of
what may be viewed as wasteful compensation practices of the
old regime.
iv. The potential hidden costs of §409A noncompliance to a buyer

include liability for the target company's failure to satisfy its tax
withholding obligations with respect to deferred amounts.
Unanticipated §409A liabilities may pass through to the buyer
for amendments or terminations of benefits that the seller may
have imposed or negotiated with its employees. The buyer may
also find itself liable to pay for §409A penalties imposed on
executives of the target company as a result of “gross-up”
provisions (discussed below) in employment contracts and plans
that the buyer may have agreed to assume.
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v. A seller, on the other hand, often wants to limit the §409A

liabilities that it may owe to its own executives (because of "gross
up" provisions) and the buyer. A seller usually will try to
minimize its obligations to indemnify its executives and the
buyer for §409A violations. A seller will also try to qualify its
§409A representations to the buyer, limit escrow amounts and
periods involved in the transaction, and attempt to eliminate the
buyer’s right to terminate an agreement for a breach of §409A
representations.
vi. Consequently, the parties to mergers and acquisitions often

must spend a considerable amount of time and money in the
pre-acquisition stage dealing with §409A issues. Many
acquisition agreements now contain specific representations
regarding §409A compliance as well as extensively negotiated
indemnity and claims period provisions. And even in the post-
acquisition setting, buyers (and sellers) may find themselves
having to deal with §409A issues. In today’s economic crisis and
the corresponding credit crunch, §409A issues may become a
deciding factor in whether a transaction goes forward or is
successful.
B. What are the basics of §409A?
i. §409A regulates “nonqualified deferred compensation plans,”

which are virtually any compensation arrangement, whether
pursuant to a company-wide plan or in a clause in an
employment agreement with a single individual, that provides
for the deferral of compensation from the year in which the
related services were performed to a subsequent year, unless
specifically excluded. Treas. Reg. §1.409A-1(a)(1) and (b)(1).
ii. Under §409A, a deferral of compensation occurs when “a service

provider” (i.e., an employee or, in some circumstances, an
independent contractor) has a "legally binding right" to
compensation in one year that is not subject to a substantial risk
of forfeiture and that is or may be payable in a later tax year.
Treas. Reg. §1.409A-1(b)(1).
a. An employee has a legally binding right to the payment

of compensation even if the payment is conditioned on
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the future performance of services or other conditions

(such as achieving the financial or performance goals) set
by the employer or “service recipient”.
b. A legally binding right may exist even if the amount may

be offset by benefits under a qualified plan or if the
amount may be reduced due to investment losses. Treas.
Reg §1.409A-1(b)(1).
c. No deferral of compensation occurs, however, if the

employer reserves the unfettered discretion to reduce or
eliminate the compensation. Treas. Reg. §1.409A-1(b)(1).
iii. To comply with §409A, a plan must be in writing, though

unwritten plans are covered by §409A and the material terms of
the plan can be set forth in more than one document. Treas. Reg.
§1.409A-1(c)(3)(i).
iv. Some of §409A’s compliance requirements include the following:
a. A plan does not satisfy the requirements of §409A unless

it is established and maintained in accordance with
§409A’s requirements.
b. Under §409A, a plan is established on the latest of the

date on which (i) it is adopted, (ii) it is effective, and (iii)
the material terms of the plan are set forth in writing.
§409A (d)(3) (a plan does not have to be in writing to be
covered). The material terms of the plan include the
amount (or the method or formula for determining the
amount) of deferred compensation and the time and
form of payment.
c. Notwithstanding the foregoing, a plan will be deemed to

be established as of the date the participant obtains a
legally binding right to a deferral of compensation,
provided that the plan is otherwise so established by the
15th day of the third month of the service recipient’s
subsequent tax year.
d. The election to defer the compensation must be made by

the end of the year preceding the year in which the
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services are rendered (with some exceptions – see Treas.

Reg §1.409A-2).
v. Generally, if an arrangement is subject to §409A, the time and

form of the payment of deferred compensation cannot be
manipulated or changed, except in narrow circumstances.
vi. As a general rule, §409A does not apply until the right to the
compensation is “vested” or not subject to a substantial risk of
forfeiture. A payment ceases to be subject to a substantial risk of
forfeiture on the first date the service provider has a legally
binding right to the payment.
vii. General "savings" provisions of a plan that purport to nullify

noncompliant plan terms, or to supply any specifically required
terms that are missing from the plan will be disregarded, but
incorporating by reference a specific term from §409A may be
permissible. Treas. Reg. §1.409A-1(c)(3)(i) and (3)(v).
viii. The payment of an amount as a substitute for a payment of

deferred compensation may be treated as the acceleration of a
payment of deferred compensation.
ix. Deferred compensation plans must be compliant in form and

operation by December 31, 2008.
x. There are reporting and withholding tax payment requirements

for the employer.
C. What are the penalties for failing to comply with 409A?
i. §409A provides, among many other things, that if employment-

related compensation qualifies as deferred compensation, and
the compensation arrangement is a nonqualified deferred
compensation plan that is not exempt from 409A or does not
comply with 409A’s requirements related to timing of elections,
distributions and funding, the employee will be hit with the
immediate income taxation in the current tax year (rather than
when received) of all amounts deferred or payable in future
taxable years to the extent not subject to a substantial risk of
forfeiture and not previously included in income, plus FICA, and
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the amounts of the purported deferral (whether actually

received or not) also will be subject to an additional 20% penalty
tax. Interest on the amounts that would have been included in
income if not deferred is assessed at a "nonpayer rate" (which is
higher than that imposed for other violations) plus 1%. IRC
§409A(a)(1)(A) and (B).
ii. Likewise, §409A invalidates any efforts between an employer

and an employee to agree to fix any §409A problems that may
later arise.
iii. Although the penalties under §409A are primarily assessed on

executives, the companies that employ them are required to
report deferred compensation and to withhold taxes and to pay
employment taxes. These employers may face tax penalties
under other tax provisions if they fail to report amounts deferred
under a nonqualified deferred compensation plan on the
employee’s W-2 form and must withhold taxes on any amounts
in the gross income of an employee under Section 409A. Notice
2005-1, Q&A 24 through 38 (Notice 2005-1 is no longer valid, but
is referred to herein for guidance purposes only).
iv. “Gross Up” Provisions. Employers may incur contractual liability

to gross-up payments to executives under employment
agreements that require employers to “gross up” or compensate
executives for unanticipated §409A liabilities.
a. The downside of a "gross up." When an employer has

“gross up” provisions in its employment agreements for
payments characterized as excess parachute payments
under IRC §4999 and/or subject to §409A, the costs to the
company can triple and the gross ups can become a
significant cost item in a merger and acquisition.
1. Employers can agree to "gross up" or increase an

executive's compensation by the amount of any
§409A liability that may be imposed on a deferred
compensation arrangement that does not comply
with §409A. However, while a "tax gross up"
provision will lessen the impact of §409A on the
executive, it will not solve the problem of the
unpaid payroll taxes (FICA, FUCA, etc.) and the
deductibility of the payments by the employer.
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2. If an employer “grosses up” the employee on the

§409A excise taxes and penalty, in a way that does
not comply with §409A, then interest and an
additional 20% penalty may also be assessed on
any “gross up” payment, and the gross up payment
will not be deductible by the employer.
b. Tax Gross-Up Safe Harbor. However, a tax gross-up will

be treated as a permissible distribution if the
employment agreement provides that the gross-up will
be paid by the end of the taxable year following the
taxable year in which the executive pays the taxes to be
grossed up; and the gross-up must, in fact, be made as
provided in the employment agreement. See Treas. Reg.
§1.409A-3(i)(1)(v).
D. What is a nonqualified deferred compensation plan under 409A?
i. A nonqualified deferred compensation plan under 409A is any

plan, agreement or arrangement (written or otherwise) that
"provides for the deferral of compensation if, under the terms of
the plan and the relevant facts and circumstances, the service
provider has a legally binding right during a taxable year to
compensation that, pursuant to the terms of the plan, is or may
be payable to (or on behalf of ) the service provider in a later
taxable year." Treas. Reg. §1.409A-1(b)(1). A "service provider"
includes an executive. Treas. Reg. §1.409A-1(f ).
ii. Examples of nonqualified deferred compensation plans

potentially subject to §409A include, but are not limited to, the
following:
a. Executive Employment Agreements with future

payouts other than base salary that may provide for
“deferral” of compensation and/or the payment of
bonuses, severance payments, post-termination
consulting and non-compete payments, post-termination
salary continuation payments, or post-termination
medical expense reimbursements in future tax years. See
Treas. Reg. §1.409A-1(c).
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b. Bonus Plans and Incentive Compensation Plans with

payments in future years are covered by §409A whether
they are:
• Discretionary;
• Formula based ($X times number of months

employed); or
• Based on individual and/or entity performance

criteria.
1. Sign-on Bonuses. If the period between when an

executive is hired and the date when payments of
a sign-on bonus are completed covers more than
one taxable year and the executive has a legally
binding right to payment in a future year, the
payment represents deferred compensation
under Code §409A. Unless the future payments of
the sign-on bonus are subject to a substantial risk
of forfeiture or, following the year in which they
cease to be subject to a substantial risk of
forfeiture, they must be paid within the 2-1/2
month "short-term deferral" exception of Treasury
Regulation §1.409A-(1)(b)(4), or these payments
must comply with, among other provisions, the
permissible distribution requirements of Code
§409A(a)(2)(A), which (as discussed below) include
a separation from service, disability, death, a
specified time (or a fixed schedule), a change in
control of a company or ownership of assets and
the occurrence of an unforeseeable emergency.
2. Performance-Based Compensation.
Compensation is performance-based if it is based
on pre-established (in writing at least 90 days
before the period starts) organizational or
individual performance criteria relating to
performance period of at least 12 months. An
employee may elect to defer performance-based
compensation if the election is made during the
performance period, but no later than 6 months
before the end of the period over which
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performance was measured and before the

performance-based compensation has become
readily ascertainable. Treas. Reg. § 1.409A-2(a)(7).
c. Severance Agreements (discussed below).
d. Change in Control Agreements (discussed below).
e. Fringe Benefit and Expense Reimbursement

Arrangements (unless there is a legally binding
entitlement that goes beyond the taxable year in
question, which may result in them being treated as
nonqualified deferred compensation plans). Treas. Reg.
§1.409A-3(i)(1)(iv)(governing expense reimbursement);
Treas. Reg. §1.409A-1(p)(defining "in-kind" benefit plans).
f. Split-dollar Life Insurance Arrangements (unless

specifically excluded).
g. ERISA “excess” plans (where the statutory limits are

exceeded under qualified plans and made up in add-on
arrangements).
h. SERPs - supplemental executive retirement plans

(usually pension type plans with multi-year benefit
payments.
1. Tax-qualified pension plans are excluded by Code

§409A(d)(1)-(2) from the list of nonqualified
deferred compensation plans subject to Code
§409A, but supplemental pension benefits
provided to executives by employment
agreements (or by supplemental pension plans
referenced in such agreements) are subject to
§409A.
i. Executive deferral plans (such as “super”-401(k) plans).
j. Stock appreciation rights.
k. Phantom stock plans.
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l. Restricted stock units (but not actual restricted stock

grants).
m. Discounted or misdated stock options (i.e., options

with exercise prices below the stocks’ fair market value)
are subject to §409A, but stock options and stock
appreciation rights are treated as deferred compensation
that is excepted from Code §409A if they have an exercise
price no less than the fair market value of the stock on
date of grant. Treas. Reg. §1.409A-1(b)(5)(i)(A)(1).
E. What Payments are Excluded from §409A’s Definition of “Deferred

Compensation”?
i. Short-term deferrals. Amounts to be paid within 2 and ½

months after the end of the year in which the payment ceases to
be subject to a substantial risk of forfeiture) are excluded from
§409A’s definition of “deferred compensation.”. Treas. Reg.
1.409A-1(b)(4).
a. Substantial Risk of Forfeiture. Under §409A, a

substantial risk of forfeiture is a risk that must apply by
the terms of the plan to the deferred amounts so the
deferrals are not treated as income to the recipient.
1. Deferred compensation is subject to a substantial

risk of forfeiture if the receipt of deferred
compensation is conditioned on the performance
of substantial future services or the occurrence of
a condition related to a purpose of the
compensation and the possibility of forfeiture is
substantial. Treas. Reg. §1.409A-1(d)(1).
2. The attainment of a prescribed level of earnings or

equity value, or the completion of an IPO can be
substantial risks of forfeiture. Treas. Reg. §1.409A-
1(d)(1).
3. An amount conditioned on the executive’s

involuntary separation from service without cause
can be subject to a substantial risk of forfeiture, if
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the possibility of such a separation from service is

substantial. Treas. Reg. §1.409A-1(d)(1).
4. Noncompete agreements or agreements to refrain

from the performance of services do not create a
substantial risk of forfeiture.
5. The addition of any risk of forfeiture or extension

of an "at risk" period is disregarded once a legally
binding right to compensation arises.
6. Elective deferrals of compensation cannot be

subject to a substantial risk of forfeiture unless the
amount subject to risk is materially greater than
the amount that is electively deferred.
7. The determination of whether deferred

compensation is subject to a substantial risk of
forfeiture is important for purposes of short-term
deferrals (discussed below), as the short-term
deferral rule requires that payment be made
within 2 1/2 months following the year in which
the amount to be paid is no longer subject to a
substantial risk of forfeiture.
ii. Stock options for the purchase of the stock of the employer or a
member of the same controlled group, including incentive stock
options, are not subject to §409A where the exercise price may
never be less than the fair market value of the underlying stock
on the date the option is granted and the number of shares is
fixed on the original date of the option grant. Treas. Reg. 1.409A-
1(b)(5)(i)(A)(1). Stock appreciation rights (if the same
requirements are met) and equity based compensation are also
excluded, Treas. Reg §1.409A-1(b)(5)(i)(B), but non-statutory
stock options are not excluded.
a. “Backdated”, “Misdated” or Discounted Options –

Under §409A’s rules, any option granted where the
exercise price could be less than the grant date fair
market value (as defined below) is deemed a discounted
option and the spread (increase in value) when vested is
immediately taxable (and subject to withholding) under
§409A.
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b. Fair market value §409A imposes stringent

requirements on the fair market valuation of the shares:
1. A public company must use either a closing trade

price or a stated average price (over a pre-
established period if the averaging period does
not exceed 30 days). Treas. Reg. §1.409A-
1(b)(5)(iv)(A).
2. A private company must satisfy the “reasonable

valuation method reasonably applied test.”
Included as reasonable are the valuation method
used consistently for all equity-based
compensation arrangements, such as the
appraisal by a reputable third party that involve
the use of the following specific factors:
• Value of tangible and intangible assets
• Present value of future cash flow
• Market value of similar companies (either

public or established by arm’s length
transactions)
• Control premiums and/or discounts for

lack of marketability
• Whether the valuation method is used for

other purposes that have specified
material effect
3. The use of an ESOP appraisal within the last

twelve months, a formula price used for regulatory
filings, or a third party’s expertise if experienced
with illiquid stock may also be reasonable
valuation methods under §409A. Treas. Reg.
§1.409A-1(b)(5)(iv)(B)(2)(iii) and (B)(1)..
4. However, a valuation will not be considered

reasonable if it is more than twelve months old or
fails to take into account all material information.
Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1).
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c. Modifications, Assumptions, Substitutions or

Replacements of Options as a Result of a Corporate
Transaction. In a merger or acquisition, equity awards
are often assumed, substituted or replaced by the
acquiring corporation.
1. Generally, the assumption or substitution of an

equity award in the context of a merger or
acquisition will not result in an impermissible
modification or be treated as the grant of a new
right or a change in the form of payment for
purposes of §409A as long as the following
requirements of Treas. Reg. § 1.409A-1(b)(4) are
met:
(i) The same aggregate spread must be

presented. Treas. Reg. § 1.409A-
1(b)(5)(v)(D).
(ii) The ratio of exercise price to FMV may not

be more favorable after the transaction.
Treas. Reg. § 1.409A-1(b)(5)(v)(D). However,
note the exception to this rule if fewer
shares are issued.
(iii) The new or assumed option must contain

all terms of the old option, except to the
extent such terms are rendered inoperative
by reason of the corporate transaction.
Treas. Reg. § 1.409A-1 (b)(5)(v)(D).
(iv) The new option or assumed option must

not give the optionee additional benefits
that the optionee did not have under the
old option. Treas. Reg. § 1.409A-1
(b)(5)(v)(D).
2. Generally, a change in an option or issuance of a

new option is considered to be by reason of a
corporate transaction, unless the relevant facts
and circumstances demonstrate that such change
or issuance is made for reasons unrelated to such
corporate transaction.
17
3. The eligible issuer of service recipient stock can

either be the direct service recipient corporation
or a corporation in a line of corporations ending
with the direct service recipient corporation. Treas.
Reg. 1.409A-1(b)(5)(iii)(E)(1).
4. In the case of adjustments to and substitutions of

options following a spin-off or similar transaction,
FMV can be determined based on market
quotations as of a predetermined date not more
than 60 days after the transaction, or based on an
average of such market prices over a period of not
more than 30 days ending not later than 60 days
after the transaction. Treas. Reg. § 1.409A-
1(b)(5)(v)(C).
5. In a change of control transaction, awards can be

"cashed-out" or substituted with a cash payment
equal to the spread between the exercise price
and the FMV of the underlying stock.
6. Modifications that may be considered the

grant of a new stock right. A modification of the
terms of a stock right, other than an extension or
renewal, may be considered the grant of new
stock right, which must be analyzed to determine
if it is deferred compensation under Section 409A.
Treas. Reg. § 1.409A-1(b)(5)(v)(A
(i) A modification is any change in the terms

of a stock right which may.provide the
grantee with a reduction in the exercise
price, an additional deferral or an
extension or renewal of a stock right.
(ii) Extensions of stock rights. Extending the

exercise period of a stock right is not a
grant of a new stock right, if it is extended
no later than the day the stock right would
have expired or the tenth anniversary of
the original stock grant.
18
(iii) Extending the Exercise Period of

Underwater Stock Options. If the
exercise period is extended when the stock
is underwater (i.e., the exercise price is
greater than the fair market value of the
stock, it will be treated as if a new stock
right had been granted, rather than as an
extension of the original stock right. Treas.
Reg. § 1.409A-1(b)(5)(v)(C)
(iv) Accelerating Exercisability. Accelerating

the time when a stock right may be
exercised may be impermissible under
Section 409A(a)(3), unless it is in
connection with a permitted distribution
event (e.g., a change in control). Treas. Reg.
§ 1.409A-1(b)(5)(v)(E).
(v) Swapping Out Underlying Stock. Unless

new stock is substituted for old stock
pursuant to a corporate transaction,
swapping out stock in a way that increases
the value of the stock is a modification of
the stock right. Treas. Reg. § 1.409A-
1(b)(5)(v)(D) and (G).
iii. Separation Pay Plans (discussed below); Some separation pay

plans that are permissible under §409A include the following:
a. Involuntary separation plans (based on amount not

exceeding 2 times the lesser of annualized compensation
or the IRS compensation limit for qualified plans
[$240,000 for 2009]) where paid by the end of the second
year after separation.
b. Window termination programs involving voluntary

terminations.
c. Reimbursement plans (including medical expenses

during the COBRA period).
iv. Certain indemnification and liability insurance plans.
19
v. Other Plans Excluded from §409A. Some other plans

specifically excluded from 409A’s definition of a nonqualified
deferred compensation plan include the following:
a. “Qualified” employer plans. Code §409A(d)(1)-

(2)(excluding tax-qualified pension plans from the status
of deferred compensation plans); Treas. Reg §1.409A-
1(a)(2).
1. Offsets. A provision for offsetting deferred

compensation with benefits accrued under a
qualified plan will not negate the existence of a
legally binding right to the deferred
compensation for §409A purposes. Notice 2005-1
Q&A-4(a), 2005-1 C.B. 274, Q&A-4(a) (Jan. 15,
2005)(herein after cited as Notice 2005-1)(no
longer valid, but cited here for guidance only).
b. Split-dollar life insurance arrangements under certain

conditions.
c. Certain foreign plans.
d. Section 457 plans.
e. Restricted stock and property (until no longer subject

to a substantial risk of forfeiture)
f. Bona fide vacation, sick leave, compensatory time,

disability pay or death benefit plans as well as
specified medical savings account plans and certain
health reimbursement arrangements. §409A(d)(1); Treas.
Reg. §1.409A-1(a)(5)(excluding these categories of
welfare benefits from nonqualified deferred
compensation plan status).
1. The reimbursement of medical expenses can be a

form of separation pay subject to Section 409A
unless it is allowed only for a limited period of
time not extending beyond December 31 of the
second calendar year following the separation
from service. Treas. Reg §1.409A-1(a)(5).
20
F. When can distributions of deferred compensation be made under

§409A?
i. Permitted Distribution Events. Except for the exemptions and

exclusions discussed elsewhere, distributions to service
providers generally may be made only in connection with the
following permitted distribution events or times:
a. Separation from Service. IRC §409A(a)(2)(A)(i) defines

payments made to an executive upon a "separation from
service" as a permitted distribution event.
1. Generally, separation from service occurs upon an

employee's death, retirement or other termination
of employment with the employer.
2. M&A Note: In an asset sale, seller and buyer may

retain discretion to specify whether an employee
who works for the seller immediately before an
asset sale transaction and for the buyer
immediately afterwards has experienced a
separation from service, as long as the transaction
involves arm’s length negotiations and the
treatment is applied consistently and specified in
writing prior to the closing date. Treas. Reg.
§1.409A-1(h)(4).
3. An employee’s separation from service must be

from all entities under common control, which
requires a near total cessation of duties for all of
those entities.
4. An employee on an approved leave of absence

will be treated as having incurred a separation
from service on the day after a six-month leave (or
longer period if the employee's right to
reemployment is a longer period as required by
applicable law).
5. A reduction in an employee’s work schedule is

presumed to be a separation from service. If the
21
level of service drops to 20% or less of the average

level of service performed during the immediately
preceding 36-month period. If the level of service
drops to a level that is 50% or more of the average
level of service performed during the immediately
preceding 36-month period, no separation from
service is presumed. No presumption applies
where the level of service is more than 20% but
less than 50%.
6. Different kinds of separations from service can

have different times and forms of payment.
(i) Payments due to a separation from service

after a change of control must be made in
a limited time period not to exceed two
years from the change of control event.
(ii) Payments due to separations from service

before or after a specified date (e.g.,
attaining age 65) or a combination of a
specified date and either a specified length
of service (e.g., attaining age 65 and 20
years of service). Treas. Reg. §1.409A-3(c).
b. Disability. §409A(a)(2)(A)(ii) permits distributions on the

date when an executive becomes "disabled," as defined in
§409A(a)(2)(C), whether or not the executive's
employment terminates on that date.
Under the final regulations, a plan can deem an employee to be

disabled if such employee is totally disabled for purposes of
receiving Social Security disability benefits. Further, an employee
can be deemed disabled if the employee is disabled pursuant to
a disability insurance arrangement sponsored by the employer,
provided such determination is at least as restrictive as the
definition of disability set forth in §409A.
c. Death. §409A(a)(2)(A) lists death is a permissible event

for payment of deferred compensation, provided the
agreement also specifies the time and method for the
payment).
22
1. Deferred compensation generally may be

distributed by the end of the calendar year of
death or, if later, by the 15th day of the third
month following death.
d. A fixed time or fixed schedule specified in the plan which,

among other things, must be objectively determinable.
1. A fixed time or schedule means that distribution

of deferred compensation will occur on fixed date,
during a specified year or pursuant to a fixed
schedule (for installments or annuity forms of
distribution.
2. A distribution date is fixed if it is non-discretionary

and objectively determinable at the time the
compensation is deferred.
3. A plan may provide for payment at the earliest or

latest of more than one of the permitted
distribution events. Treas. Reg. §1.409A-3(b).
4. The specified date of payment rule allows for

payments later within the same calendar year if
the specified payment date is missed. Treas. Reg.
§1.409A-3(d).
5. Tax gross-up payments are made pursuant to a

fixed time or schedule if the plan sets forth the
time or schedule and payments are made no latter
than the end of the tax year following the tax year
in which the taxes giving rise to the gross-up
payments are paid. Treas. Reg. §1.409A-3(i)(1)(v).
e. Earn-out Provisions. Earn-outs are treated as paid at a

specified time or pursuant to a fixed schedule in
conformity with the requirements of §409A if paid on the
same schedule and under the same terms and conditions
as payments to shareholders generally pursuant to a
change in the ownership of a corporation that qualifies as
a change in control event or as payments to the service
recipient pursuant to a change in the ownership of a
substantial portion of a corporation's assets that qualifies
23
as a change in control event. Treas. Reg. § 1.409A-

3(i)(5)(iv).
f. Change of Control. IRC §409A(a)(2)(A)(v) states that "to

the extent provided by the Secretary, a change in the
ownership or effective control of the corporation, or in
the ownership of a substantial portion of the assets of the
corporation" constitutes a permissible distribution event.
1. A change in control event includes all of the

following:
(i) A change in ownership of a corporation.

Treas. Reg. § 1.409A-3(i)(5)(v)(A)(a person
or group acquires more than 50% of the
voting stock of the corporation., although
the plan can designate a level higher than
50% as a change in control}.
(ii) A change in effective control of a

corporation. Treas. Reg. § 1.409A-
3(i)(5)(vi)(A)(a person or group of persons
acting as a group acquire 30% or more of
the total voting power of the corporation’s
stock or a majority of the corporation’s
board of directors is replaced by members
not endorsed by the previous board
members).
(iii) Change in the ownership of a substantial

portion of a corporation's assets. Treas.
Reg. § 1.409A-3(i)(5)(vii)(A)(a person or
group acquires assets of the corporation
with a fair market value at least equal to
40% of the FMV of the corporation’s total
assets, determined immediately before the
transaction and without regard to the
liabilities associated with the assets).
2. A plan may provide for a more restrictive

definition of change in control, but may not
distribute deferred compensation based on a less
restrictive definition of change in control.
24
3. M&A Note: A payment will treated as occurring

because of a change in control event if the
payment is made due to the corporation’s
irrevocable action (under the terms of the plan) to
terminate the plan and to distribute the plan’s
benefits within 30 days preceding the change in
control event and 12 months from the corporate
action to terminate the plan. Treas. Reg. § 1.409A-
3(j)(4)(ix)(A).
4. To qualify as a change in control event: (i) the

occurrence of the event must be objectively
determinable and (ii) any requirement that any
other person, such as a plan administrator or
board of directors compensation committee,
certify the occurrence of a change in control event
must be strictly ministerial and not involve any
discretionary authority. §409A(a)(2)(A)(v); Treas.
Reg. §1.409A-3(g)(5)(i).
5. The arrangement may provide for a payment on

any change in control event, and need not provide
for a payment on all such events, provided that
each event upon which a payment is provided
qualifies as a change in control event. Treas. Reg. §
1.409A-3(i)(5)(i).
6. To constitute a change in control event as to the

service provider, the change in control event must
relate to:
(i) the corporation for whom the service

provider is performing services at the time
of the change in control event;
(ii) the corporation that is liable for the

payment of the deferred compensation (or
all corporations liable for the payment if
more than one corporation is liable); or
(iii) a corporation that is a majority shareholder

of a corporation identified in (1) or (2)
above, or any corporation in a chain of
25
corporations in which each corporation is a

majority shareholder of another
corporation in the chain, ending in a
corporation identified in (1) or (2) above.
Treas. Reg. § 1.409A-3(i)(5)(ii)(A).
7. “Single trigger” and “double trigger” change in

control provisions.
(i) Employment agreements with a "single

trigger" change of control provision
(whereby the deferred compensation is
distributed solely upon the occurrence of a
change of control), the agreement's
definition of change in control must be
consistent with §409A's definition.
(ii) Employment agreements with "double

trigger" provisions (i.e., where distribution
occurs only after separation from service
following a change in control), a plan's
definition of change in control need not
meet §409A's definition as long as the
distribution pursuant to a subsequent
separation from service after the change in
control complies with §409A.
8. Non-corporate change of control transactions.

Because §409A's change-in-control rules currently
address only corporate transactions, pending
further guidance, non-corporate change in control
transactions involving partnerships and other
entities will by governed by §409A's change-in-
control rules. Notice 2005-1, Q&A 7.
g. An unforeseeable emergency (limited to the amount

necessary to satisfy the emergency)
ii. The timing of Permitted Distributions. Under §409A, a

distribution does not have to be made immediately upon the
occurrence of a permitted distribution event. Instead, it can be
made at a time fixed by reference to a permitted distribution
event (e.g., three months after separation from service). In
26
addition, the distribution will be deemed to have been made on

a timely basis if it is made within the same calendar year or, if
later, by the 15th day of the third month following the
distribution date specified by the plan.
a. An early distribution of deferred compensation is

permitted it the distribution is made no earlier than 30
days prior to the designated distribution date.
b. If the plan specifies that distribution will occur on a

specified payment date or within a specified period (e.g.,
within 60 days following a distribution event), the
distribution will be deemed to have been timely made if
distribution occurs within the period and the period
begins and ends within the same tax year or the period
does not exceed 90 days. Treas. Reg. §1.409A-3(d).
c. Generally, only a single time and form of distribution may

be designated for each permitted distribution event, with
two exceptions:
1. For distributions that do not occur because of

separation from service or at a fixed
time/schedule, a plan may provide for a different
time and form of distribution for a distribution
event occurring before or after a specified date;
and
2. For distributions that occur upon separation from

service, a plan may provide for a different time
and form of distribution with respect to a
separation from service that occurs:
• within two years after a change in control;

or
• before or after a specified date, a specified

age or a specified combination of date and
age.
iii. Restrictions on Delaying the Time and Manner of

Distribution Elections. If permitted by the plan, an employer
27
may delay distribution of the employee's deferred compensation

if:
a. With respect to amounts payable at a specific time, the

election to delay payment is made at least 12 months
prior to the date the payment is otherwise scheduled to
be made;
b. The election does not take effect for at least 12 months

following the date the election is made; and
c. With respect to distributions other than on account of

death, disability or unforeseeable emergency, the
distribution commencement date is delayed for at least
five years from the date the payment would have
otherwise been made.
iv. Restrictions on Accelerating the Time and Manner of

Distributions.
a. Generally, there can be no acceleration of payment of the

deferred compensation - with some exceptions, including
the following:
1. Domestic relations order
2. Compliance with ethics laws or conflicts of interest

laws
3. “Small” cash-outs ($15,000 or less)
(i) Cashout Rules. A service recipient may

exercise discretion to cash out a service
provider's entire amount deferred under a
plan at any time so long as the amount
deferred under the plan is less than the
applicable dollar amount under Section
402(g)(1)(B) for that calendar year.
b. State and Local Taxes, FICA, RRTA Tax and Foreign

Taxes. The acceleration of payments is permitted under a
deferred compensation plan to cover state and local
28
taxes, income taxes and employment taxes, FICA, RRTA

taxes, and foreign taxes.
c. Plan terminations (subject to certain conditions)
d. Bona Fide Settlement Agreements. Payments do not

become deferred compensation subject to Section 409A
if the right to such payments arises as part of a settlement
between the service provider and the service recipient of
bona fide legal claims, such as wrongful termination,
FLSA violations, retaliation and harassment claims, but
this exception does not apply to amounts that would
have been deferred and paid regardless of whether the
claim existed. Treas. Reg. §1.409A-1(b)(12).
1. If a bona fide dispute exists between an employer

and an employee regarding the employee’s right
to a payment under the plan, the plan may
provide for accelerating the time or schedule of
payments as part of a settlement of the dispute;
2. However, a payment is presumed not to meet the

requirements of a bona fide settlement if it is not
discounted by at least 25 % from the disputed
payment amount or if it is made proximate to a
downturn in the employee’s financial condition.
Treas. Reg. § 1.409A-3(j)(4)(xiv).
29
G. What Are 409A’s Rules on Severance Pay Arrangements?
i. §409A exempts certain separation pay arrangements. Treas. Reg.

§1.409A-1(b)(9).
a. Short-term Deferrals. Public and private company

severance arrangements that result from involuntary
terminations are exempt from §409A where the terms of
the plan require that such severance pay be paid out in
full within either (1) in the year of such involuntary
termination of service or (2) prior to the later of (a) March
15 of the following year or (b) 2 ½ months following the
end of the fiscal year of the employer in which the
involuntary termination occurs or the amount is no
longer subject to a substantial risk of forfeiture. Treas.
Reg. §1.409A-1(b)(4)(i)(A).
1. The only exceptions to the requirement that the

payments must be made within the above short-
term deferral period is if:
(i) Administrative Impracticability. Making

the payment earlier was administratively
impracticable due to unforeseen
circumstances;
(ii) Threat of Insolvency. Making of the

payment would jeopardize the ability of
the service recipient (e.g., employer) to
continue as a going concern;
(iii) Nondeductability. Code section 162(m)

would prevent a current deduction of the
payment. Treas. Reg. §1.409A-1(b)(4)(ii).
(iv) However, for all three delaying events, the

event must have been unforeseeable and
the payment must be made as soon as
practicable thereafter. Treas. Reg. §1.409A-
3(d).
2. Note: A plan should specify that payments are to

be made by the fifteenth day of the third month
30
after year end or within 2-1/2 months of the end

of the taxable year in which the separation from
service occurred, so that if the short-term deferral
payment date is missed, the specified date of
payment rule (discussed above) can be used to
allow payment later within the same calendar year
if the specified payment date is missed. Treas.
Reg. §1.409A-3(d).
b. “Two Times, Two Year” Exemption. Severance

arrangements involving involuntary terminations that are
paid after the end of the time periods described in the
above paragraph are also exempt from §409A if the
aggregate amount of severance payments does not
exceed the specified amount over the specified time
period.
1. The specified amount is the lesser of (1) two times

the employee's annual compensation or (2) two
times the limit on annual compensation that may
be taken into account for qualified plan purposes
under IRC Section 401(a)(17)(for 2009, $240,000)
in the calendar year preceding the year in which
the separation from service occurs.
2. The specified time period is the period that starts

from the date of involuntary termination of
service and ends no later than the end of the
second calendar year in which the separation from
service occurs. Treas. Reg. §1.409A-1(b)(9)(iii).
c. The “Six Month” Payment Rule for ”Specified

Employees” of Publicly Traded Companies. For public
companies, severance arrangements that do not meet
either of the exemptions discussed above such
arrangements may nonetheless be 409A compliant if the
payments are not made to (1) a "Specified Employee"
(defined below) and (2) are paid pursuant to a fixed
payment schedule.
1. "Specified Employee" means, any employee of a

publicly traded employer who is (1) an officer of
the employer with annual compensation greater
31
than $130,000, (2) a 5% owner of the employer or

(3) a 1% owner of the employer having annual
compensation greater than $150,000.
2. An entity need not be traded in the United States

to be a publicly traded company for purposes of
this rule; it can be traded anywhere in the world
and the determination of who is a specified
employee is made on a "controlled group" basis.
3. Privately-Held Company Severance

Arrangements. Private company severance
arrangements that do not meet the §409A
exemptions discussed above must comply with
§409A's rules. Because the "Specified Employee"
concept does not apply to private companies,
their severance arrangements will comply with
§409A if the payments are paid pursuant to a fixed
payment schedule, regardless of whether the
severance arrangements involve involuntary
terminations, resignations for "Good Reason" or
"constructive terminations."
d. Collectively Bargained ("CBA") Separation Pay Plans.
e. Involuntary Separation Plans.
1. Involuntary separation from service occurs only

when the employer exercises its "unilateral
authority" to terminate the employee's services. It
includes a failure to renew a contract when it
expires and an employee’s resignation for “Good
Reason” as defined in the final regulations. Treas.
Reg. §1.409A-1(n).
2. Generally, determining whether the separation

was voluntary is determined according to the
particular facts and circumstances, and if the
employee signs a document indicating that the
separation was voluntary, then a rebuttable
presumption arises that it was.
32
3. An involuntary separation plan must meet the

requirements of the “Two Times, Two Year”
Exemption (discussed above). In other words, the
separation payment under an involuntary
separation pay plan must be paid no later than
December 31 of the employee's or employer's
second taxable year after the separation. Treas.
Reg. §1.409A-1(b)(9)(iii)(B);Treas. Reg. §1.409A-
1(n).
4. A voluntary quit by the employee is not a

separation from service with the only exceptions
being a resignation for “Good Reason” or a
resignation pursuant to a “window program.”
Treas. Reg. 1.409A-1 (b)(9)(i).
f. A Window Program will qualify for an exception to

§409A to the extent it is a program whose purpose is to
make separation pay available to employees who apply
to the employer under the program during a limited
period of time of not more than 12 months and who
separate during that period whether or not additional
requirements are specified by the program; and
1. The separation pay under the window program

does not exceed the amount permissible under
the “two times, two year” exception.
2. Note: If the employer has a pattern of providing

window programs on a more or less periodic basis,
the programs will lose the exemption. Treas. Reg.
§1.409A-1(b)(9)(vi).
3. In determining whether a pattern exists, the IRS

will consider whether the window program relates
to a specific business event or condition, the
degree to which the separation payments relate to
such event or condition, and whether the event or
condition is isolated or merely a permanent
feature of the employer's on-going business.
4. §409A Rules on “Good Reason” Terminations.

Executive employment agreements that contain a
33
clause permitting executives to terminate their

employment for “good reason” (e.g., a breach of
the agreement by the employer, the transfer to a
distant location, or the diminution of duties or
title) and receive enhanced severance pay, must
comply with §409A requirements in order to be
considered an involuntary termination (necessary
to maintain the severance pay plan exemption).
(i) §409A “Good Reason” requirements

include: (1) the existence of bona fide
conditions equivalent to an involuntary
termination; (2) the conditions must
require action by the employer that results
in a material adverse impact to the
employee (e.g., the diminution of job
duties and compensation changes), (3)
whether the compensation paid as a result
of a "good reason" termination is
equivalent to compensation to be paid on
an actual involuntary termination, and (4)
whether executives must give their
employers notice and a stated period of
time to “cure” or correct the conditions
causing the good reason to terminate
employment. Treas. Reg. §1.409A-1(n)(2)(i),
(ii).
(ii) The "Safe Harbor" for “Good Reason”

Separations. Treas. Reg. 1.409A-1(n)(2)(ii)
lists the following circumstances that may
be included in a definition of Good Reason
so that a resignation for “Good Reason” will
qualify as a “separation from service”:
a) The separation from service must

occur during a pre-determined
limited period of time not to exceed
two years following the initial
existence of one or more of the
following conditions arising
34
without the consent of the service

provider;
b) The amount and form of the

payment for good reason must be
substantially identical to the
payment that would be made for an
involuntary separation;
c) The contract must provide that the

employee must give notice to the
employer of the good reason within
90 days of when it occurs and the
employer must have at least 30
days to remedy the condition and if
it does so, no payment will be
made. Treas. Reg. §1.409A-1(n)(2).
d) Any separation must occur within a

pre-determined time period not to
exceed two years following the
initial occurrence of one of the
following circumstances without
the employee’s consent:
(1) A material diminution in the

service provider's base
compensation;

service provider's authority,
duties, or responsibilities;

authority, duties, or
responsibilities of the
supervisor to whom the
service provider is required
to report, including a
requirement that a service
provider report to a
corporate officer or
employee instead of
35
reporting directly to the

board of directors of a
corporation (or similar
governing body with
respect to an entity other
than a corporation);

budget over which the
service provider retains
authority;
(5) A material change in the

geographic location at
which the service provider
must perform the services;
or
(6) Any other action or inaction

that constitutes a material
breach by the service
recipient of the agreement
under which the service
provider provides services.
Treas. Reg. 1.409A-
1(n)(2)(ii)(A)(1)-(6).
g. Foreign Separation Pay Plans (relating to separation

payments required by foreign laws).
h. Separation Expense Reimbursements Payment Plans.

Under this exception, even if a separation was voluntary,
the amounts paid for reimbursement of medical expense
or COBRA premiums would not be covered by Section
409A, but only for the time period permitted under
COBRA. Treas. Reg. §1.409A-1(b)(9)(v)(B).
i. Special Note about Separation Pay Plans that result in

forfeiture of other deferred compensation: A
severance agreement or plan that results in the
cancellation, replacement, substitution or forfeiture of an
existing entitlement to other deferred compensation in
exchange for severance pay may be presumed to be not
36
in compliance and may also result in the impermissible

acceleration of the deferred compensation under the
other plan, especially If the separation is voluntary. Treas.
Reg. §1.409A-1(b)(9)(i); Treas. Reg. § 1.409A-
3(f )(recognizing that any payment as a substitute for the
payment of deferred compensation will be treated as a
payment of deferred compensation).
1. Otherwise, whether separation pay not subject to

§409 is a substitution for, or a replacement of,
deferred compensation under another plan that is
subject to §409 will be determined according to
the facts and circumstances of each case. One
"factor" that can rebut the presumption that arises
in a voluntary separation is whether the
separation plan payment is materially less than
the forfeited, substituted or replaced amount.
2. An initial election to defer the payment of

separation pay if the separation pay was the result
of arm’s length negotiation at the time of the
separation from service, provided that the
employee did not have a pre-existing right to the
separation pay before negotiations began. Treas.
Reg. § 1.409A-2(a)(11).
III. Sample TARP and §409A Executive Employment Agreement Provisions
(Disclaimer: These are samples. They should not be used without careful analysis of
the applicable facts and law.
A. Sample §409A Executive Employment Contract Provisions (Pre-

Acquisition Setting)
i. "Change in Control" means:
a. a change in the ownership of the Parent or the Employer

(as defined in Treasury Regs. Section 1.409A-3(i)(5)(v))
(other than a transfer to a group comprised of members
of the Owners or an Employee Stock Ownership Plan
established by Parent); or
37
b. a change in effective control of the Parent or the

Employer (as defined in Treasury Regs. Section 1.409A-
3(i)(5)(vi)), or
c. a change in the ownership of a substantial portion of the

assets of the Parent or the Employer (as defined in
Treasury Regs. Section 1.409A-3(i)(5)(vii)).
However, a Change in Control shall not occur under Paragraphs

(a), (b) or (c) if the Owners continue to be the beneficial owners,
directly or indirectly, of at least 30% of the combined voting
power of the then outstanding securities of the Parent (or of the
Employer for a Change in Control under Subparagraph (c)
involving the Employer), and no other person or group is or
becomes the beneficial owner, directly or indirectly, of securities
of the Parent (or the Employer for a Change in Control under
Subparagraph (c) involving the Employer) having combined
voting power greater than that beneficially owned, directly or
indirectly, by the Owners.
ii. “Disability” for the purposes of this Agreement, shall be deemed

to have occurred if Parent determines that Executive has a
physical or mental impairment, as confirmed by a licensed
physician selected by Parent, which renders Executive unable to
engage in any substantial gainful activity, and is expected to
result in death or is expected to last for a continuous period of
not less than twelve (12) months. This definition of "Disability" is
intended to comply with §409A of the Internal Revenue Code of
1986, as amended, ("Code"), and the regulations promulgated
thereunder, and shall be interpreted and administered in
accordance with said provisions. Termination due to disability
shall be deemed to have occurred upon the first day of the
month following the determination of Disability as defined in
the preceding sentence.
iii. “Separation from Service” means Executive’s termination of

employment with Parent or the Employer which constitutes a
“separation from service,” as such term is defined under §409A of
the Internal Revenue Code of 1986, as amended (the “Code”) or
applicable guidance or regulations thereunder.
iv. §409A “gross up” clause [Note: Extensively negotiated and

drafted prior to 2007 final regulations] (i) It is intended that
38
any income or payments to Executive provided pursuant to this

Agreement or other agreements or arrangements contemplated
by this Agreement (any such income or payments being referred
to for purposes of this Section 4.3(d)(ii) as “Payments”) will not be
subject to the additional tax and interest under §409A(a)(1)(B) of
the Code (a “§409A Tax”). The provisions of the Agreement and
such other agreements or arrangements will be interpreted and
construed in favor of complying with any applicable
requirements of §409A of the Code (“§409A”) necessary in order
to avoid the imposition of a §409A Tax. The Employer, Parent and
Executive agree to amend (including retroactively) the
Agreement and any such other agreements or arrangements in
order to comply with §409A, including amending this
Agreement or other agreements or arrangements contemplated
by this Agreement to facilitate the ability of Executive to avoid
the imposition of, or reduce the amount of, any §409A Tax. The
Employer, Parent and Executive shall reasonably cooperate to
provide full effect to this provision and consent to any
amendment described in the preceding sentence shall not be
unreasonably withheld by any party hereto. Notwithstanding
the foregoing, if any Payments due or made to Executive are
subject to a §409A Tax solely as a result of the negligence or
intentional act or omission of the Employer or Parent, then
Executive shall be entitled to receive a gross-up payment (a
“§409A Gross-Up Payment”) in an amount equal to (A) the §409A
Tax on any Payments, plus (B) any federal, state, and local income
taxes, employment taxes (including FICA) or other taxes payable
by Executive with respect to the §409A Gross-Up Payment, in
order to put Executive in the same position he would have been
had the §409A Tax not become due with respect to any
Payments; provided, however, that the Employer and Parent shall
only be responsible to make a §409A Gross Up Payment with
respect to the §409A Tax on Payments made (i) in contravention
of the terms of this Agreement or other agreements or
arrangements contemplated by this Agreement, or (ii) in
contravention or violation of any §409A guidance or authority
that is promulgated or effective after the date hereof; further
provided, that the Employer and Parent shall not be responsible
to make a §409A Gross-Up Payment with respect to the §409A
Tax on the Payments if (1) Executive refuses or fails, following a
specific written request of the Employer or Parent, to make an
election to alter the form and/or timing of any Payment
39
(including by amending this Agreement or other agreements or

arrangements contemplated by this Agreement pursuant to this
subsection(ii)) that could reasonably be expected to result in the
reduction or avoidance of any amount of §409A Tax while
minimizing (to the extent reasonably practicable) the delay in
such Payment to Executive, (2) Executive refuses or fails,
following a specific written request of the Employer or Parent, to
take any reasonable action which would have the effect of
reducing or eliminating the §409A Tax that may become due
with respect to any Payment by use of the correction program
described in IRS Notice 2007-100 or any other program made
available by the Internal Revenue Service or under applicable
law, or (3) a payment practice which is commonly accepted as
compliant with the requirements of §409A pursuant to which a
Payment is made is determined by the Internal Revenue Service
to be subject to a §409A Tax.
v. Clauses disclaiming any §409A representations.
a. This Release is intended to comply with §409A of the

Internal Revenue Code of 1986, as amended, but the
parties agree that the Employer is making no guarantee,
warranty, or representation in this Release regarding the
tax effect of this Agreement or the position that may be
taken by any benefit plan administrator or plan regarding
the effect of this Release upon Employee’s rights,
benefits, or coverage under any benefit plan.
b. The Company intends all payments and other

consideration provided by this Agreement to be
compliant with Internal Revenue Code § 409A; however,
the Company recommends that you review all such terms
with your own counsel or accountant to ensure
compliance with § 409A.
B. Sample §409A Incentive Compensation Plan Provisions
In the event of any merger, consolidation or reorganization of the Company

with or into another Company other than a merger, consolidation or
reorganization in which the Company is the continuing Company and which
does not result in the outstanding shares of Common Stock being converted
40
into or exchanged for different securities, cash or other property, or any

combination thereof, there shall be substituted, on an equitable basis as
determined by the Committee, for each share of Common Stock then subject
to an Award under the Plan, the number and kind of shares of stock, other
securities, cash or other property to which holders of shares of Common Stock
of the Company will be entitled pursuant to the transaction so long as
substitution complies with Treasury Regs. Section 1.409A-1(b)(5)(iii)(E)(4) and
Section 1.409A-1(b)(5)(v)(D).
i. Other Provisions. Awards under the Plan may also be subject to

such other provisions (whether or not applicable to the Award
granted to any other participant) as the Committee determines
appropriate, including without limitation, provisions for the
installment purchase of Common Stock under Stock Options,
provisions for the installment exercise of Stock Appreciation
Rights, provisions to assist the participant in financing the
acquisition of Common Stock, provisions for the acceleration of
exercisability or vesting and/or early termination of Awards in
the event of a change of control of the Company (provided that
such provisions do not result in an acceleration that is prohibited
under Treasury Regs. Section 1.409A-3(j), provisions for the
payment of the value of Awards to participants in the event of a
change of control of the Company, provisions for the forfeiture
of, or restrictions on resale or other disposition of, Common
Stock acquired under any form of Award, provisions to comply
with Federal and State securities laws, or understandings or
conditions as to the participant's employment in addition to
those specifically provided for under the Plan. For purposes of
this Section 12, a "change of control" means a change in the
ownership or effective control of a corporation or a change in
the ownership of a substantial portion of assets of a corporation
pursuant to Treasury Regulation § 1.409A-3(i)(5).
ii. Time of Granting of Awards; Fair Market Value. The date of

grant ("Date of Grant") of an Award shall be the date specified by
the Committee on which an Award under this Plan will become
effective (which date shall in no event be earlier than the date on
which the Committee takes action with respect thereto),
provided that for a non-qualified stock option the date shall be
the date on which the maximum number of shares that can be
purchased under the option and the minimum purchase price
are fixed or determinable, and further as for Stock Appreciation
41
Rights the date on which the maximum number of shares which

the right is based and the setting of a date upon which the
appreciation of the right is to commence, provided that in the
case of an Incentive Stock Option, the Date of Grant shall be the
later of the date on which the Committee makes the
determination granting such Incentive Stock Option or the date
of commencement of the Participant's employment relationship
with the Company. Except as otherwise expressly provided in a
written Award, for purposes of this Plan and any Awards
hereunder, the "Fair Market Value" of a share of Common Stock
shall be closing price of a share of the Company's Common Stock
as reported on the Nasdaq National Market (or such other
consolidated transaction reporting system on which such shares
are primarily traded) on the date of calculation (or on the next
preceding trading date if shares of Common Stock were not
traded on the date of calculation); provided, however, that if
shares of the Company's Common Stock are not at any time
readily tradeable on a national securities exchange or other
market system, "Fair Market Value" shall mean a value
determined by a reasonable application of a reasonable
valuation method determined pursuant to Treasury Regulation §
1.409A(1)(b)(5)(iv)(B).
iii. §409A of the Code. To the extent applicable, it is intended that

this Plan and any Awards granted hereunder comply with the
provisions of §409A of the Code. This Plan and any Awards
hereunder shall be administrated in a manner consistent with
this intent, and any provision that would cause this Plan or any
Award hereunder to fail to satisfy §409A of the Code shall have
no force and effect until amended to comply with §409A of the
Code (which amendment may be retroactive to the extent
permitted by §409A of the Code and may be made by the
Company without the consent of Participants). Any reference in
this Plan to §409A of the Code will also include any proposed,
temporary or final regulations, or any other guidance,
promulgated with respect to such Section by the U.S.
Department of the Treasury or the Internal Revenue Service.
iv. Duration, Termination and Amendment. This Plan shall

terminate upon the earlier of a termination by the Board, or at
such time as there shall be no remaining shares available for
grant hereunder, or June 20, 2012. Also, by mutual agreement
42
between the Company and a participant hereunder, under this

Plan or under any other present or future plan of the Company,
Awards may be granted to such participant in substitution and
exchange for, and in amendment or cancellation of, any Awards
previously granted such participant under this Plan, or any other
present or future plan of the Company, provided any such
amendment, termination, substitution, exchange or cancellation
does not result in an acceleration that is prohibited under the
Treasury Regs. Section 1.409A-3(j). No amendment, termination,
substitution, exchange or cancellation may adversely affect any
incentive awards for which the Participant was previously
eligible to receive. The Board may amend the Plan from time to
time or terminate the Plan at any time, subject to any
requirement of stockholder approval required by applicable law,
regulation, or stock exchange rule. However, no action
authorized by this Section 17 shall reduce the amount of any
outstanding Award or adversely change the terms or conditions
thereof without the participant's consent.
C. Sample TARP Separation Agreement Provisions [with “claw back”

clause]
i. Section 12. The parties agree that this Release is intended to

comply with the rules and regulations of the Troubled Asset
Relief Program (“TARP”). To the extent that the Employer later
determines in the exercise of its reasonable discretion that the
terms of this Release or the payments hereunder do not comply
with TARP or the Employer may not deduct the full amount of
the payments to Executive for federal income tax purposes, she
agrees that the Employer may alter or reduce the amount or
nature of the payments under this Release in order to comply
with TARP and obtain the maximum income tax deduction of the
payments to Executive permitted by law.
a. The parties further agree that the payments under this

Release are not being made on account of any
involuntary termination of Executive’s employment
(including but not limited to any “good reason”
resignation or constructive termination) or on account of
any change of control involving the Employer and do not
43
constitute parachute payments or excess parachute

payments, as those terms are defined under TARP or
other applicable tax rules.
b. The parties also agree that any and all payments made by
the Employer pursuant to this Release are subject to
recovery (“claw back”) by the Employer and immediate
repayment by Executive in the event that the Employer
determines in the exercise of its reasonable discretion
that they were made on the basis of financial statements
or other criteria (including but not limited to violations of
the Employer’s Code of Conduct and policies on ethical
behavior) that later turn out to have been materially
inaccurate.
44
About Paul E. Starkman
Mr. Starkman is the Chair of the Labor & Employment Law Practice Group at Arnstein &
Lehr LLP. Since joining the firm in 1986, he has acquired extensive experience counseling
public and private employers on a broad range of personnel matters and corporate transactions
with employment-related issues. He has also successfully handled litigation involving “cutting
edge” discrimination claims, actions seeking injunctive relief, class actions, compensations and
benefit claims and other employment related issues in federal and state courts throughout the
country.
Professional Activities and Achievements
Mr. Starkman is a Fellow of the College of Labor and Employment lawyers. He is an active
member of the American Bar Association and the Society of Human Resources Professionals
(SHRP). He is a Co-Chair of the Contingent Worker Subcommittee, a past Chair of the At-
Will Employment Subcommittee and has served as the Management Chair of the Worker
Dislocation Sub committee of the ABA Employment Rights & Responsibilities Committee.
Mr. Starkman also frequently speaks at conferences and seminars throughout the country
Paul E. Starkman sponsored by the Bureau of National Affairs (BNA), the Practicing Law Institute (PLI),
American Law Institute-American Bar Association (ALI-ABA), and other professional
(312) 876-7890 direct groups on employment issues. He has also appeared on television and other media outlets on
(312) 876-6290 fax employment-related issues.
Recent Publications and Lectures
Chicago Office Mr. Starkman has been quoted in such national publications as the Wall Street Journal, the
120 S. Riverside Plaza National Law Journal, Lawyer USA Today, among others.
Suite 1200
Chicago, IL 60606-3910 Mr. Starkman is one of the principal authors of Employment Arbitration: Law and Practice (West
2007-2008), the 1,200 page treatise on employment arbitration and updates are available for
purchase at: http://west.thomson.com.
Mr. Starkman also authored “Measuring the Effectiveness of Corporate Compliance and
Ethics Programs: An Outside Counsel’s Perspective,” 1661 PLI Corp 225 (Practicing Law
www.arnstein.com
Institute (March-June 2008)
Some of his other published articles and written materials include:

“Refuling Assistance for Drivers with Disabilities” 32 ABA Mental and Physical Disability Law
Reporter 493 (July August 2008). Co-authored with John D. Kemp and Elizabeth Doyle.
A 90-minute DVD, “Video Leadership Seminars™: Winning Legal Strategies for

Employment & Labor Law” (ReedLogic. September 2006), featuring Paul Starkman
discussing winning strategies for harassment and discrimination litigation and other
commonly faced employment issues. Available for purchase directly from ReedLogic at
1-877-34-LOGIC, www.reedlogic.com/rl79.asp, and at Amazon.com, Barnes & Nobel.
Ingram Book Group, Baker & Taylor and through Bowker at its title listings for Books/
DVDS in Print.
“Protecting Your Company’s Competitive Advantage – Rethinking Restrictive Covenants
& Alternative Strategies” (Executive Reports – Aspatore Publishing 2006). Available
for purchase at http://www.reportbuyer.com/business_services/law/protecting_
companys_competitive_advantage.html. Paul Starkman’s 40-page research report written
for company executives features strategies for protecting confidential information and
forming more effective restrictive covenants.
“Handling Requests For Personal Attorneys During Internal Investigations,” 94 Illinois Bar Journal
290 (May 2006) and reprinted in The Brief 26 (Spring 2007) the newsletter for the ABA
Tort Trial & Insurance Practice Section.
“Perspectives of Outside Management Counsel on Sexual Harassment Cases,” published

in the book entitled Dealing With Employee Lawsuits: Strategies for the Prevention and Defense
of Workplace-Related Claims (Aspatore 2005). Available at www.aspatore.com/store/
bookdetails.asp?id=61.
Mr. Starkman’s article on “Blogging and Instant Messaging in the Workplace” was
published in Law Technology News (Nov. 2005).
“The Employment Law Impact of the Sarbanes-Oxley Act,” 28 Employee Relations Law
Journal 25 (Spring 2003).
“Open Issues after Circuit City: Still No Easy Answers on Mandatory Arbitration,” 27
Employee Relations Law Journal 69 (Spring 2002).
“The ADA’s Essential Job Function Requirement: Just How Essential Does An Essential
Job Function Have To Be,” 26 Employee Relations Law Journal 43 (Spring 2001).
“Mergers and Acquisitions: A Checklist of Employment Issues,” 13 DePaul Business Law

Journal 47 (Fall/Spring 2000/2001).
“Answering the Tough Questions about Alcoholism and Substance Abuse Under the
ADA and FMLA,” 25 Employee Relations Law Journal 43 (Spring 2000).
“Learning the New Rules of Sexual Harassment: Faragher, Ellerth and Beyond,” 66
Defense Counsel Journal 317 (July 1999) (Selected as one of the year’s best articles by the
Insurance Law Review.).
“The Good, the Bad, and the Uncooperative: Dealing with the Uncooperative Employee
During an Internal Investigation,” 25 Employee Relations Law Journal 69 (Summer 1999).
Education
DePaul University College of Law, Chicago, Illinois (J.D., 1984)

University of Wisconsin/Madison (B.A., 1980)
Bar Admissions
State of Illinois
U.S. Court of Appeals for the Seventh Circuit
U.S. District Court for the Northern, Central, and Southern Districts of Illinois
(including Trial Bar)

A Primer On The Impact of The New Economic Stimulus Laws and IRC 409A On Executive Compensation in Mergers and Acquisitions

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A Primer On The Impact of The New Economic Stimulus Laws and IRC 409A On Executive Compensation in Mergers and Acquisitions

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He is a fellow of the College of Labor and Employment and a co-chair of the

I. The New Economic Stimulus Laws: The American Recovery and

i. On February 17, 2009, the American Recovery and Reinvestment

ii. ARRA imposes a more comprehensive set of executive

B. ARRA’s General Standards. ARRA requires TARP Recipients to meet the

i. Any compensation plan that encourages any senior executive

ii. A claw-back provision allowing the TARP Recipient to recover any

iv. During the TARP obligation period, golden parachute payments

v. ARRA prohibits any compensation plan that would encourage

C. Prohibition Against Accrual of Certain Bonus, Retention Award, and

i. During the TARP Assistance Period, TARP Recipients are

b. has a value not greater than one-third of the total

ii. The ARRA prohibition against the payment or accrual of bonus,

a. If the financial institution received less than $25 million in

b. If the financial institution received at least $25 million but

c. If the financial institution received at least $250 million

d. If the financial institution received $500 million or more in

iii. The Treasury Department can decide to apply the ARRA

D. Board Compensation Committee

E. Luxury Expenditures Limitation Policy

Each TARP Recipient's board of directors must implement a company-wide policy on

• office and facility renovations;

• aviation or other transportation services; or

• other activities or events that are not reasonable expenditures

F. Nonbinding Shareholder “Say on Pay” Votes on Executive

G. Treasury Department’s Review of Prior Payments to Executives

The Treasury Department is to review bonuses, retention awards, and other

the purposes of the revised executive compensation requirements or TARP, or were

H. Certification of Compliance with ARRA’s Executive Compensation

Each TARP Recipient is subject to the $500,000 compensation deduction limitation of

II. The Impact of §409A on Executive Compensation in Pre- and Post-

A. How Does §409A Affect Mergers and Acquisitions?

i. Enacted in 2004, §409A of the Internal Revenue Code may be the

iii. In the pre-acquisition setting, sellers often try to make their

iv. The potential hidden costs of §409A noncompliance to a buyer

v. A seller, on the other hand, often wants to limit the §409A

vi. Consequently, the parties to mergers and acquisitions often

B. What are the basics of §409A?

i. §409A regulates “nonqualified deferred compensation plans,”

ii. Under §409A, a deferral of compensation occurs when “a service

a. An employee has a legally binding right to the payment

the future performance of services or other conditions

b. A legally binding right may exist even if the amount may

c. No deferral of compensation occurs, however, if the

iii. To comply with §409A, a plan must be in writing, though

iv. Some of §409A’s compliance requirements include the following:

a. A plan does not satisfy the requirements of §409A unless

b. Under §409A, a plan is established on the latest of the

c. Notwithstanding the foregoing, a plan will be deemed to

d. The election to defer the compensation must be made by

services are rendered (with some exceptions – see Treas.

v. Generally, if an arrangement is subject to §409A, the time and

vii. General "savings" provisions of a plan that purport to nullify

viii. The payment of an amount as a substitute for a payment of

ix. Deferred compensation plans must be compliant in form and

x. There are reporting and withholding tax payment requirements

C. What are the penalties for failing to comply with 409A?

i. §409A provides, among many other things, that if employment-

the amounts of the purported deferral (whether actually

ii. Likewise, §409A invalidates any efforts between an employer

iii. Although the penalties under §409A are primarily assessed on

iv. “Gross Up” Provisions. Employers may incur contractual liability

a. The downside of a "gross up." When an employer has

b. Fair market value §409A imposes stringent