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.