Any contractual commitment involves risk, but for bonuses and commission plans, wage and tax laws multiply that risk through statutory penalties and, in some cases, automatic multiple damages. A carefully designed compensation plan encourages strong performance while protecting against an expensive surprise. Automatic Penalties for Wage Violations If the description of an incentive compensation plan arrangement does not match what the business intended, or it was drafted casually or was not reviewed for compliance with state wage laws, the risk is not just a possible disagreement with an employee. Under federal and state laws, employers face automatic penalties for unpaid wages—and sometimes, incentive compensation counts as a “wage” for these purposes. For example, in Massachusetts, if a commission is paid even one day later than it was due, the business automatically owes the employee the original amount of the commission plus twice that amount as a penalty. With such significant downside risk, it is crucial to ensure wage law compliance. Drafting Assumptions and Ambiguities Employees often have the right to enforce incentive compensation arrangements. Clear rules become especially important since courts often interpret an ambiguous contract against the side that prepared it—which, for incentive compensation, is almost always the employer. This section discusses just a few of the issues that can easily arise without tight drafting. We advise working with counsel to make sure that the written document matches the company’s intention (and minimizes ambiguities) and protects the company against unexpected outcomes. When is a former employee entitled to commissions or bonuses? Employers (sometimes) assume that an incentive compensation plan ends when the employment relationship ends. But it doesn’t always work that way. If an annual bonus plan does not require current employment at the time of payment, an employee who resigns on January 1 might claim a bonus for the year that just ended. Similarly, if a commission plan is silent on what happens post-employment, an employee might be entitled to a commission on a deal that closes after the employee has left. Employers often want to limit the compensation paid to employees who are already out the door. For example, an annual, discretionary bonus might have an “in-seat” requirement (that is, the employee must still be working at the time that annual bonuses are paid in order to receive one). A commission plan might specify that a commission is not “earned” until a customer signs a purchase order or until the business receives payment—and that workers do not earn any further commissions after departure. Whether or not conditions to payment work is often a function of applicable state law, as discussed below. What if two employees earn the same commission? In a strong, collaborative workplace, multiple employees might work on the same deal. That’s great—until the business discovers that multiple employees have earned the same commission, costing the business double or triple the incentive compensation for just one sale. A clear commission plan avoids this problem. There is no mandatory approach, and a business has flexibility to create the right incentive for its workforce. One company may decide that just one, designated deal leader receives the commission; another may divide the commission among a team. Businesses can also choose whether to apply a firm rule to all situations or retain discretion in how they apportion credit. But without any rules—even flexible ones—a company could be stuck paying multiple commissions and potentially losing its profit margin on the deal. Is the bonus really discretionary? When a company establishes annual bonus criteria in advance, it tells people how to build toward success for mutual benefit. This can be a valuable tool for company growth. However, if the factors are too rigid, the business might have painted itself into a corner. For example, an executive could be contractually entitled to a seven-figure bonus because revenue was up or a new office opened—even if that executive mishandled a crisis or the stock price is tanking. Sometimes, a non-discretionary bonus payable upon achievement of clear, well-thought-out metrics, really is the right move. But when the business wants to preserve flexibility, it should bake that right into the language from the beginning. Legal Limits on Incentive Compensation Rules Businesses have substantial leeway to design incentive structures that work best for their own goals, but only to a point. As noted earlier, state laws often govern when companies must pay their employees. For example, Illinois requires that commissions are paid on a monthly basis. Even states without a similar requirement may require that commissions or bonuses are paid within a certain amount of time after they are earned. If commissions are fully earned once the customer pays, but commissions are only paid once a quarter, the company might accidentally violate state law. (And as discussed above, that could result in automatic multiple damages.) A written policy that clearly defines when a commission or bonus is earned, and that creates a legally-compliant window for payment, reduces the risk of an accidental violation. When there is a risk that customers will return products or cancel services, a company often considers a commission clawback and will deduct the amount of a paid commission from a future salary or later commission. This can seem like a simple solution, but it raises numerous legal issues. For example, some states have strict rules about deductions from wages and do not allow companies to subtract a prior commission from a later salary or commission payment. Additionally, paying an employee a commission in one calendar year and then recouping it in a later year can cause significant tax complications for the employee. A misstep could result in the employee’s entitlement under state law to a return of the clawback plus multiple damages as a wage penalty. Companies may be able to achieve a similar result in another way, such as through meticulously-defined conditions that must be met before a commission is earned, but especially careful drafting is necessary for such an approach, and it raises additional tax complications. Avoiding Tax Penalties Deferred compensation (including commissions and bonuses) must either be exempt from or comply with Internal Revenue Code Section 409A. A deferred compensation arrangement that violates Section 409A can result in imputed income (without payment of any cash), a 20% excise tax penalty and a premium interest charge penalty. Additional information on Section 409A can be found here. When Section 409A applies is not always obvious.  For example, if an employee is entitled to an annual bonus as long as she is employed on the date the bonus is paid, the bonus is exempt from Section 409A. However, if the employee is entitled to an annual bonus as long as she was employed on December 31 (but the bonus is paid after year-end), the bonus is potentially subject to Section 409A’s requirements. Making matters more complex, violations can arise under the controlling document (such as an employment agreement or commission plan) or with how the company handles incentive compensation in practice. Employers generally do not face monetary penalties in the event of a Section 409A violation (the entire liability is on the employee), but failures to report and withhold a Section 409A violation can trigger tax penalties on the employer. Because a faulty document cannot be fixed by correct behavior in the future, it is crucial to work with counsel on Section 409A compliant documents at the outset. Whether an existing arrangement violates Section 409A and how to fix it is a complex matter that should be addressed sooner rather than later. Conclusion Incentive compensation is a field for business creativity and customization, all within barbed-wire boundaries that can result in unintended consequences for the employer and employee alike. By working with counsel to navigate wage and tax law requirements, companies can create incentive compensation plans that reflect their vision for the future, align their best interest and their employees’, and steer clear of wage or tax penalties. This article is not legal advice. If you are interested in discussing any of these topics further, please contact a member of the Employment & Benefits Practice Group.

Hiring a new employee is typically a moment of optimism—and sometimes, the relationship really does go wonderfully for its entire length and ultimately ends on good terms. But when that hope is treated as an assumption, companies make themselves vulnerable. If a client-facing employee does not have a non-solicitation agreement, a business’s customers could be poached. A new employee, hired because of their great industry relationships, might actually have an undisclosed non-compete or non-solicit with a competitor—and suddenly, your business is being sued. Strong contracts are an essential part of protecting the business against unexpected outcomes. ​Using Contracts to Protect Business Assets By requiring upfront agreement on boundaries to protect the business—such as agreements regarding non-solicitation, non-competition, confidentiality, invention assignment, and non-disparagement—a business both discourages disloyalty in the first place and has ammunition if an employee later crosses the line. Companies often invest substantial resources into relationships, whether with employees or with business partners, but these relationships can be vulnerable to poaching. For example, an employee may look effective and helpful to customers because of institutional support that costs the business time and money, but which is invisible to the customer, who assumes the individual employee deserves all credit. A non-solicitation agreement bars a former employee from trying to ​hire the company’s employees and/or from trying to do business with the company's clients for a fixed period of time after the relationship ends. This protects the company's investment in those relationships. Most businesses depend on information that they would not want a competitor to have. If a confidentiality agreement is not written clearly enough, it might turn out to be a picket fence where barbed wire is needed. Confidential information is not just cutting-edge scientific research—it can also include hard-won insight into specific customer preferences, proprietary analysis of market trends, and much more. New hires who are likely to be given access to confidential information should generally be required to sign a confidentiality agreement that firmly protects the business’s informational assets. A confidentiality agreement needs to appropriately define the confidential information being protected and the expectations on the employee (such as not disclosing that information or using it outside non-disclosure and return of information at the end of employment). Similarly, invention assignment agreements ensure that the employee’s ideas—particularly those in line with the company’s own business, research, or development—belong to the business. This prevents employees from collecting a salary while developing ideas that would be valuable to the business—but keeping those ideas to themselves, possibly to use in competition against the business. Non-solicitation and confidentiality agreements are important, but they can be difficult to enforce in time to prevent damage. A business often will not know that confidential information was given away or misused until it is much too late to the put the horse back in the barn. A non-competition agreement prevents a former employee from competing against the business for a fixed amount of time. Especially when a former employee has had access to confidential information and to valuable business relationships, this can be a valuable for tool for avoiding misbehavior. If an employee cannot work for a competitor at all, they are less likely to be in situations where they might violate other restrictions. Finally, a non-disparagement agreement protects the company’s reputation. However, some employees may balk at agreeing to this upfront, before the relationship has even begun. Companies should consider whether a non-disparagement agreement is a term worth including as a hiring requirement. As with most employment terms, a company may decide that this term will be included for certain hires, but not all. Agreements should match the specific needs of each employment situation; to be enforced, it is essential that they also match state law. State employment laws vary substantially. One state may require that a confidentiality agreement have an exception for sexual harassment; another may require certain carve-outs to invention assignment agreements; a third may impose an annual compensation minimum for non-solicitation agreements; a fourth may require that employees are told of their right to consult with counsel before signing a non-competition agreement. An agreement that does not comply with applicable state law might not be enforceable, which means the company does not have the protection it thought it had. In some cases, a noncompliant contract raises additional issues: for example, in California, non-competition agreements are banned in most circumstances, and businesses face a penalty if they require an employee to sign one. Businesses should work with counsel on agreements that are appropriate to each circumstance and applicable state and federal law. Hiring from Competitors Conversely, businesses often hire people who have worked in the field before—perhaps even at a competitor. Even though the business didn't sign the employee’s prior employment agreement and is not a party to it, when a former employee breaches a contract to benefit a competitor, the competitor is typically sued alongside the employee.[1] Upfront preparation can reduce risks. When hiring a new employee, a business may require the employee to confirm (as a written requirement of employment) that this job will not conflict with any other contractual commitments of that employee. If the employee raises a concern about another contract, the business should review the contract with counsel. In some instances, there may be an argument that the contract is not enforceable, and the employee and the business will each need to decide whether they are willing to take a risk. In some instances, there may be a confidentiality or non-solicitation restriction but no non-compete. In those cases, although employment is allowed, the former employer will likely be suspicious and may sue. When there are confidentiality and non-solicitation restrictions, businesses should strongly consider instructing the employee not to engage in any conduct that would violate those restrictions, and it may choose to be even more proactive by keeping the employee siloed from the customers or parts of the business that raise the contractual risk. Those protections can often be time-limited, such as to the amount of time remaining on a non-solicitation agreement. ​When ​a former employee does not have any prior agreement, a company has much more flexibility, but risks still exist. For example, the federal Defend Trade Secrets Act allows a business to sue for misappropriation of trade secrets, and a former employer may allege that a company misappropriated its trade secrets through the departed employee. Companies can reduce risks by providing instructions to employees that they should not use or disclose confidential information from any other business in their work. Requiring Commitment Employees sometimes engage in outside work. Guardrails set important expectations and give the business a clear exit ramp if an employee breaks the rules. For some positions, it may be appropriate to restrict all outside work. Most businesses would not want their CEO to be managing another business on the side. In those cases, requirements that an employee to devote their full business efforts to the position, and not to engage in outside work, makes the expectation both clear and firm. In other situations, outside work may be appropriate; additionally, some states have pro-moonlighting laws that protect employees’ off-hours activities. In those cases, agreements or policies create a moat of protection around the business. Businesses can set expectations around not participating in moonlighting during working hours, not using the business’s equipment for an outside venture, and similar issues. Conclusion By establishing clear rules up-front, a business encourages the right type of behavior from the beginning, and it is better able to defend itself against attacks from current and former employees—often the people who best know its vulnerabilities and its proprietary secrets. [1] Whether the former employer’s claim against the new employer is strong, or even viable at all, are different questions and depend on many factors, including specific facts and state law. But even an unsuccessful claim can force expensive defense costs and distractions from the business.   Further resource: Listen to Erika Todd discuss legal concerns for freelancers with fulltime jobs on The Freelance Mindset Studio podcast here. Coming up: The next article in this series will discuss key issues to know about creating incentive compensation plans—including the risks of a casual or ambiguous arrangements and triggers for tax penalties. This article is not legal advice. If you are interested in discussing any of these topics further, please contact a member of the Employment & Benefits Practice Group.