Oh Won’t You Stay…Until the Bonus is Paid

by Brenda Berg

A new interpretation by the Colorado Department of Labor and Employment (CDLE) could have significant tax impacts under Internal Revenue Code Section 409A (409A). Many bonus and incentive programs require that the intended recipient remain employed with the employer through the date of payment. If the employee quits before the payment date, the employee is not entitled to receive the bonus. In fact, many bonuses are granted specifically in order to retain the employee.

In Interpretative Notice and Formal Opinion (INFO) #17, the CDLE interprets the Colorado Wage Act as prohibiting an employer from requiring the employee be employed on a certain date in order to receive a bonus, if all other conditions to receive the bonus have been met. See my colleague’s article here for more discussion about the new guidance in general.

If the CDLE interpretation is applied to retention bonuses, the bonuses might not, in fact, be forfeitable if the employee quits before the payment date. Since these bonuses are typically designed to be exempt from 409A tax rules under the “short term deferral” exception which requires there to be a “substantial risk of forfeiture,” this could mean that there is no longer a substantial risk of forfeiture. The amount could be considered deferred compensation that is subject to 409A – and all of 409A’s restrictions and an extra 20% tax for any violation. Earlier “vesting” and disregard of “substantial risk of forfeiture” could have other tax and accounting impacts as well, including the timing of federal/state income taxation and FICA taxation, and which taxable year is allocated the company deduction under the “all-events test” for liabilities.

For example, an employer’s calendar year bonus may be payable in the following year after financial statement preparation/review/board certification/etc., but subject to the requirement that the individual remain employed through the actual payment date. If the bonus cannot be forfeited even if the individual quits before the intended payment date, then there would presumably be deferred compensation (earned and vested in one calendar year and paid in a later calendar year beyond the “short-term deferral” period) that is subject to 409A. Complying with 409A may not be difficult where the payment date is sufficiently specific – but being subject to 409A restricts the employer from paying earlier or later than the intended date, among other things. The unintended imposition of 409A rules onto the bonus structure would open up many traps for an unwary employer – with tax consequences of any 409A violation falling primarily on the employee.

This interpretation would have even greater impacts – and difficulties for compliance – on other types of awards that are common, such as restricted stock unit or incentive award arrangements that extend over many years (to the extent they would be otherwise subject to the Colorado’s Wage Act). In many of these arrangements, the only “vesting” condition is that the individual continue to be employed. If these “time-based vesting” awards are no longer effective in Colorado, employers’ legitimate purpose of rewarding retention of key employees would be thwarted.

It seems unlikely that Colorado intended this result. An example in Info #17 (which is based on the facts in an actual case) describes an extreme factual situation: the employer fires the employee the day before the bonus is payable. In contrast, arguably if a primary condition of the bonus is retention itself, perhaps that is sufficient to take a retention bonus out of the purview of Info #17. However, Info #17 does not appear to make that distinction. If the guidance was intended to address only the extreme type of employer behavior, we hope that the CDLE will clarify the guidance accordingly.

Employers should incorporate these considerations into any new bonus and incentive arrangements, and consider the possible impacts on any already-existing arrangements.