Business conceptAfter stepping down from running the family oil business (see last month’s article), Jed Clampett runs Mama’s Fried Pies, his late wife Rose Ellen’s fried pie business. With business booming, Jed decides to hire Elly May as the Vice President of Marketing so he can spend more time in the kitchen rather than sales. If Elly May remains with the company for a full five years, she will receive a base salary plus a $50,000 bonus, payable in $10,000 increments over five years with each increment vesting at the end of the calendar year (e.g., the first $10,000 vests on December 31, 2015) but not payable until the following June 1st. Does this retention bonus structure risk additional taxes to Elly May and Mama’s Fried Pies?

Internal Revenue Code Section 409A

Yes. Mama’s Fried Pies’ bonus agreement with Elly May does not comply with IRS Section 409A because the payment is not made by March 15, 2016. The vesting 2015 bonus must be included in Elly May’s 2015 taxable income when it vests. Worse yet, Elly May owes regular taxes plus a 20% excise tax ($2,000) on the bonus amount, plus interest at the underpayment rate plus one percent. Under the Internal Revenue Code Section 409A, Mama’s should have paid the vested retention bonus (a) on a predetermined date; (b) pursuant to a fixed schedule of payments; or (c) no later than March 15th of the calendar year following the year of vesting.

Tilting the Scales in Your Favor

To ensure that your bonus plan – either as an employee or paid by you as the employer – complies with the Internal Revenue Code, confer with your tax attorney or accountant to avoid the penalties of an IRS illegal bonus plan. Executives and employees receiving a retention bonus should confirm the legality of the arrangement before agreeing, and then consult with their employer. Likewise, employers must conform their bonus plans with the Internal Revenue Code to avoid conflicts, and possible litigation with their key employees. Now is the best time to review these bonus plans. Recently, the Internal Revenue Service ruled that if a bonus plan does not meet Section 409A’s requirements, but the company corrects the bonus plan no later than the year before the bonus first vests, the plan will be compliant.

Kudos to Jason Luter, ERISA and deferred compensation expert at Gray Reed, who just authored a client alert on this issue and assisted in editing this article.