Many community banks have been under fire recently. Added regulatory burdens, additional disclosure responsibilities, cleaning up bad loans, streamlining the organization, staying ahead of cybersecurity threats, and, perhaps most important, trying to make money in a flat economy – these all challenge bankers.The economy seems to be improving slowly, the regulatory threats seem less, most banks have dealt with their bad loans, and cybersecurity will be an ongoing struggle. There is a slight sigh of relief from many clients and an opportunity to take a breath. During this “lull,” perhaps bankers should look at some of the basic assumptions, strategic plans, and particularly executive compensation (“Exec. Comp.”) programs. It may not be what you need. 

 

Most Exec. Comp. programs contain part of four components: 

Every bank and company must decide what combination of incentives provide the best motivation for leaders of that bank. One of any board’s most important challenges is designing the Exec. Comp. program. That’s why boards of directors spend so much time developing these programs. Unfortunately, many boards do not have the training or sophistication to understand all of the consequences of their actions, so they rely too much on the senior executive officers and outside consultants to guide them. Often, those senior executive officers also do not fully understand the legal implications, and consultants have their own agendas. 

 

We recently were brought in on a transaction in which senior executive officers were provided a supplemental executive retirement plan (“SERP”). This SERP was rich, providing the executive lifetime payments after retirement and 15 years of payments to survivors if the participant died while still employed. The obligations vested over time, but all obligations vested fully upon a change of control. This plan was sold to the bank with an insurance policy that covered the cost of the pay-outs if the executive died prematurely, while employed. It created a terrific reason for a life insurance policy, and it provided a rich future benefit to the executive, but it was potentially disastrous for the bank. 

 

For instance, no one at the bank understood that this committed the bank (for an indefinite period) to pay much of the salary of two executives after they retired! This future liability was unfunded, unless one of them died while employed by the bank. Neither did anyone at the bank understand that the terms of the SERP violated the Safe Harbors under Sections 280G and 409A of the Internal Revenue Code, creating excise tax liability for the executive and rendering those payments nondeductible by the bank for tax purposes. The liability and the tax effect were a virtual “poison pill” against any future merger of the bank with another financial institution. The bank found itself faced with a possible merger that was fair for the bank’s shareholders, but the merger was contingent upon negotiating out of the SERP. The deal might not have gone through with the SERP in place. No board wants to be in that position. 

 

Why was that SERP a problem? In summary fashion, a board should review some of the arcane tax rules when choosing an executive benefit plan. These include the “golden parachute” restrictions in Section 280G and the deferred compensation restrictions in Section 409A. 

 

Section 280G is complicated, but basically (along with Section 4999) it adds a 20 percent excise tax to any payment or series of payments required because of a change in control if the payments exceed 2.99 X the average of the executive’s last five years of taxable gross income. Also, if the payment vests upon change in control, and the payment otherwise is tied to performance (bonus?), the entire payment is a “parachute” payment. This Section does not apply to small business corporations, partnerships, most LLCs, tax-exempt companies, or where shareholder approval is obtained. Shareholder approval involves complex rules that try to ensure that the shareholders understand the issue. That is a difficult and expensive process for a public institution. 280G also makes the nonconforming payment ineligible for normal tax deductions. In other words, the payments may not be deducted as an expense for tax purposes, which, depending on the bank’s tax rate, “adds” another 25-35 percent to the after-tax cost. 

 

As an example, ABC Bank is a successful community bank with 432,000 shares outstanding. It has a marginal federal income tax rate of 30 percent, and a state income tax rate of six percent. It typically pays its CEO $250,000 and its CFO $150,000 annually in taxable compensation. This is fully deductible for tax purposes. The annual, after-tax cost to the bank for both executives is $256,000 plus bonus. Both executives have four-year employment agreements that vest and are payable in full upon a change in control of the bank. The salaries are the same as this year’s, but the executives also have the ability to earn up to $50,000 each in performance bonuses. The bank negotiates an excellent contract to sell to XYZ Bancorp. The total compensation of both executives, including bonuses, vests at closing, and they must be paid in full within six months after closing. XYZ has calculated the total costs for each executive for purposes of 280G, including the bonuses vesting early and in full, and it exceeds the allowable amount (2.99 X Annual Cost) by a total of $800,000. This means that there will be an excise tax on the executives of a total of $160,000. It also means that the excess payment no longer qualifies for tax deduction, which will cost XYZ $288,000 in lost taxes. As a result, XYZ may demand a $0.67 reduction in the per share purchase price ($288,000/432,000 shares). If not fixed, this may kill the deal. Who do you think the shareholders will hold responsible? 

 

The application of Section 409A adds to this problem. 409A applies to “nonqualified deferred compensation.” This is defined as a present right to taxable compensation paid in a future year. This does not apply to 401K and pension plans, but it may apply to SERPs and other “retirement” plans that are not constructed carefully. Limited exceptions exist for amounts payable within two and a half months after the year in which the payment right vests. This exception is highly technical. Consult someone familiar with these plans to ensure that it works. 

 

Violating the 409A rules results in immediate taxation to the employee and, similar to 280G, a possible 20 percent tax penalty. If the bank established the plan with a violating provision in 2010, and it discovered the problem in 2014, the employee also may have an interest penalty dating back to the plan inception. Both a plan whose language violates Section 409A (even though the action does not – “documentary failure”) AND an action that violates 409A (even if the plain language of the plan does not – “operational failure”) create a violation of 409A. And, because the rules are highly technical, the bank and the executives sometimes feel like they have been under “double secret probation” from “Animal House.” It is common for this to be a complete and very expensive surprise for everyone involved. 
 

Why does a bank care about 409A or 280G if the penalties only apply to the executives, not the bank? How would you expect an executive to react when she finds out that the plan the bank provided her costs her back taxes and a 20 percent penalty? Would she think that should be the bank’s problem? If the executive cannot pay the penalty, it might then be the bank’s problem. Also, the buyer usually wants to employ and properly motivate the executive. How do you motivate an executive who, as a result of the deal, had to pay tens of thousands to the IRS and is angry at all involved parties? This is a nightmare for the executive and the bank. It damages the bank’s reputation and puts future offers to executives in question. 

 

Problems like this generated a trend prior to 2008 for banks to agree to “gross up” (pay the taxes) for violation of 280G and 409A in an Exec. Comp. program. This is not recommended because it creates an unknown, unfunded liability for the bank. It is simply bad policy. If the plan is poorly designed, the potential liability can be large, and sometimes close to the cost of the compensation. No forward-thinking board should agree to an unknown, unfunded liability. That is why it is critical to consult someone who understands these plans thoroughly, including the tax implications. Even if the plan is already in place, a review of that plan may reveal both the potential problems and provide an opportunity to fix those problems. This helps both the bank and the executives achieve the incentive package they want, without hampering the activities of the bank. 

 

If you have any questions about this, or any community banking issue, please contact our Community Banking Practice Group.