Learn how to avoid or overcome the common issues of administering nonqualified deferred compensation plans with change of control triggers.

One of the reasons to tie deferred / equity compensation to employer stock (including SARs and phantom stock) is the ability to subject it or a portion thereof to applicable earn out terms or to extend certain vesting conditions through and beyond the change in control. That is an area under IRC Section 409A (the primary law regulating deferred compensation and its taxation) where technical compliance requirements and business goals align very well.

What are the common pitfalls and challenges of administering NQDC plans with change of control triggers?

Nonqualified deferred compensation (NQDC) plans are a popular way to reward and retain key employees by allowing them to defer part of their income and taxes until a later date. However, NQDC plans also come with complex rules and regulations that can create challenges for both employers and employees, especially when there is a change of control event. A change of control event is a situation where the ownership or management of the company changes significantly, such as a merger, acquisition, or buyout. In this article, we will discuss some of the common pitfalls and challenges of administering NQDC plans with change of control triggers, and how to avoid or overcome them.

1 What are change of control triggers?

Change of control triggers are provisions in NQDC plans that specify what happens to the deferred amounts in the event of a change of control. Depending on the plan design and the terms of the trigger, the deferred amounts may be paid out immediately, accelerated, delayed, forfeited, or modified. Change of control triggers are intended to protect the interests of the employees and the company in case of a major transition, but they also introduce legal, tax, and operational issues that need to be carefully considered.

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Thomas M. Greene

Executive Compensation & ERISA Partner at Wagner Law Group
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One of the reasons to tie deferred / equity compensation to employer stock (including SARs and phantom stock) is the ability to subject it or a portion thereof to applicable earn out terms or to extend certain vesting conditions through and beyond the change in control. That is an area under IRC Section 409A (the primary law regulating deferred compensation and its taxation) where technical compliance requirements and business goals align very well.

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Debby Morris

President at AccessHope | Board Director | Audit Chair | Author of Unbreakable Determination
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Change of control provisions (“CIC”) are key and have different implications from an employer and employee perspective. They also have implications on equity and compensation. Employee: CIC provisions can be single or dual trigger. Single trigger means your equity/comp payout is accelerated (meaning you get paid) when the event sale/acquisition event occurs. No other requirements must be met. Dual trigger means your equity/compensation is accelerated when two things occur as spelled out in the merger agreement. Usually those are 1) the sale/acquisition and 2) elimination of your job. Employers structure it this way as they don’t want to lose key employees when a sale/acquisition occurs UNLESS the key employee roles eliminated.

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Noel Anderson, NQPA

VP Executive Benefits at Madison Brokerage
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Change in control distributions are optional. The employer always has the right to invoke a plan termination upon a change in control, too. I see a lot of privately held companies terminating their plans because they thought it would be a good idea when they set it up. That, unfortunately, gives key management a good reason not to go to work for the new owner. In turn, that means that the seller of the company sets up a new retention package, or potentially doesn't hit their earn out numbers upon acquisition.

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2 How to comply with Section 409A?

Section 409A of the Internal Revenue Code is the main law that governs NQDC plans and imposes strict rules on how and when the deferred amounts can be paid. One of the key requirements of Section 409A is that the timing and form of payment must be fixed at the time of deferral and cannot be changed later, unless certain exceptions apply. Change of control triggers may qualify as one of the exceptions, but only if they meet specific criteria and definitions. For example, a change of control event must be objectively determinable, not subject to discretion, and based on a bona fide business purpose. If a change of control trigger violates Section 409A, the deferred amounts may be subject to immediate taxation, interest, and penalties.

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Debby Morris

President at AccessHope | Board Director | Audit Chair | Author of Unbreakable Determination
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Complying with 409a provisions in a corporate transaction is key. Hire one of the Big Four to fully and comprehensively evaluate key criteria in evaluating 409a implications. It sounds easy, but there are lots of details that are important to the analysis and determining individual tax implications in advance of the transaction close. The rules are specific and must be followed precisely to be of value. It’s not something to let amateurs address - hire the right tax experts to run a 409A analysis on all impacted directors and officers to make sure you have it right!

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3 How to align with corporate goals and culture?

Another challenge of administering NQDC plans with change of control triggers is to ensure that they align with the corporate goals and culture of the company. Change of control triggers can have a significant impact on the motivation, performance, and retention of key employees, depending on how they are structured and communicated. For example, if the triggers are too generous or too easy to activate, they may create a golden parachute effect that encourages employees to seek or accept a change of control, even if it is not in the best interest of the company or its shareholders. On the other hand, if the triggers are too restrictive or too uncertain, they may create a golden handcuff effect that discourages employees from leaving or pursuing other opportunities, even if they are unhappy or dissatisfied with the new management or direction of the company.

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4 How to manage risks and liabilities?

A third challenge of administering NQDC plans with change of control triggers is to manage the risks and liabilities that may arise from them. NQDC plans are unsecured and unfunded promises to pay, which means that the deferred amounts are subject to the claims of the company's creditors in case of bankruptcy or insolvency. Change of control triggers may increase the likelihood or severity of such claims, especially if they result in large or lump-sum payments that deplete the company's assets or cash flow. To mitigate this risk, some companies may use trusts, insurance policies, or other arrangements to protect or secure the deferred amounts, but these may also have tax, legal, or financial implications that need to be evaluated.

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5 How to communicate and educate?

A final challenge of administering NQDC plans with change of control triggers is to communicate and educate the participants and stakeholders about them. Change of control triggers can be complex and confusing, and may affect the participants' decisions and expectations about their deferred compensation. Therefore, it is important to provide clear and consistent information and guidance about how the triggers work, what they mean, and what they entail. This may include providing plan documents, statements, notices, disclosures, FAQs, webinars, workshops, or other resources that explain the plan features, benefits, risks, and consequences of change of control events.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Noel Anderson, NQPA

VP Executive Benefits at Madison Brokerage
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The article appears to discuss change in control as an automatic trigger, embedded in a legal document governing the plan. Is this really needed in today's day and age? The plan sponsor can always have the option to terminate the plan upon a change in control, with or without accelerating vesting. Do we need to "hard code" it or can we wait and see what the buyer looks like? Handing key people a golden parachute automatically might cost the seller some money, because they might be hard to recruit back to the new company if needed.

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What are the common pitfalls and challenges of administering NQDC plans with change of control triggers?

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1 What are change of control triggers?

2 How to comply with Section 409A?

3 How to align with corporate goals and culture?

4 How to manage risks and liabilities?

5 How to communicate and educate?

6 Here’s what else to consider

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