- Severance Pay Arrangements and Code Section 409A
- April 10, 2006
- Law Firm: Dinsmore & Shohl LLP - Cincinnati Office
Section 409A of the Code imposes restrictions on "nonqualified deferred compensation plans." For this purpose, the term "nonqualified deferred compensation plan" means "any plan that provides for the deferral of compensation, other than (1) a qualified employer plan, or (2) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan." No statutory exclusion exists for severance pay or similar separation pay plans. Many clients are not aware that Section 409A covers severance or separation pay plans. These plans can take the form of a formal plan document, or may be just a paragraph in an employment agreement. Employers sponsoring a severance plan or arrangement need to make sure it complies with Section 409A.
Under the Proposed Regulations, severance or "separation pay" plans or arrangements are generally considered to be subject to Section 409A unless they meet the short-term deferral exception or one of the exclusions from Section 409A.
The earliest effective date of the Proposed Regulations is January 1, 2007. Thus, sponsors of severance pay plans or arrangements have until the end of 2006 to adopt amendments to comply with Code Section 409A.
The Short-Term Deferral Exception to Code Section 409A
Under the Proposed Regulations, compensation that qualifies as a "short-term deferral" is not treated as deferred compensation under Section 409A. Compensation is subject to the short-term deferral exception if the terms of the plan require payment by the later of (1) 2½ months after the end of the employee's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture, or (2) 2½ months after the end of the employer's first taxable year during which the amount is no longer subject to a substantial risk of forfeiture.
Compensation is generally treated as subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation. According to the preamble to the Proposed Regulations, compensation which is payable upon a voluntary termination of employment is not subject to a substantial risk of forfeiture, even if the compensation is only payable in the event of a voluntary termination for "good reason."
Severance Exemptions or Exclusions from Code Section 409A
If a severance pay arrangement does not qualify for the short-term deferral exception, it may still be exempt from the requirements of Section 409A if it satisfies a special exemption for severance pay arrangements contained in the Proposed Regulations.
The Two Times Exemption. This is the primary exemption for severance pay arrangements that provide payments upon the employee's involuntary termination of employment. (Except in the case of a "window program" (as described below) arrangements which pay benefits upon a voluntary termination, even for good reason, are not eligible for the exception). The exemption applies as follows: (1) all payments must be made by the end of the second year following the year in which the involuntary termination occurs, AND (2) the total amount of payments may not exceed two times the lesser of: (a) the employee's annual compensation for the calendar year preceding the calendar year in which termination occurs; OR (b) the limit on compensation under Code Section 401(a)(17) for the calendar year preceding the calendar year in which termination occurs (the limit is $220,000 for 2006).
Collectively Bargained Separation Pay Arrangement. A collectively bargained separation pay arrangement is a separation pay arrangement that provides benefits for an involuntary separation from service and that meets the following conditions: (1) the separation pay arrangement is contained within an agreement that the Secretary of Labor determines to be a collective bargaining agreement; (2) the separation pay provided by the collective bargaining agreement was the subject of arms length negotiations between employee representatives and one or more employers; and (3) the circumstances surrounding the agreement evidence good faith bargaining between adverse parties over the separation pay to be provided under the agreement.
Window Programs. Under the Proposed Regulations, voluntary terminations from service may be treated as eligible for the two times exemption or the collectively bargained exemption if they occur pursuant to a "window program." Window programs are employer-established programs that provide severance pay in connection with a termination of employment, within a limited time period (no greater than one year). A program will not be considered a window program, however, if the employer establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time.
Reimbursement of Expenses. Reimbursement arrangements are generally exempt from Section 409A provided that all reimbursements are made by December 31 of the second year following the termination of service. The exemption only applies to the reimbursement of certain expenses:
- outplacement expenses
- moving expenses
- medical expenses
- expenses that would be deductible as a business expense by the employee
- employer in-kind benefits
- other types of de minimis payments that do not exceed $5,000 in the aggregate during any given taxable year
Aggregation of Plans
Section 409A aggregates similar types of plans, such as account balance plans. Thus, a problem with an aggregated plan can affect all other similar types of plans maintained by the employer. The Proposed Regulations provide that involuntary severance pay plans or arrangements are a separate type of plan. Thus, an involuntary severance plan that does not comply with Section 409A will not disqualify any other type of deferred compensation plan.
However, voluntary severance pay plans may be lumped together with other plans of the same type, e.g. other account balance plans and thus, a noncompliant voluntary severance pay plan could disqualify other deferred compensation plans maintained by the Company.
Section 409A Compliance
Under Code Section 409A and the Proposed Regulations, severance pay plans that do not satisfy the exceptions described above must comply with Section 409A. Section 409A generally provides that all compensation deferred under any nonqualified deferred compensation plan, including a separation (or severance) pay plan, which does not comply with Section 409A is includible in gross income to the extent that it is not subject to a substantial risk of forfeiture and to the extent not previously included in gross income.
A plan does not comply with Section 409A if at any time during the tax year, the plan fails to meet the requirements for (1) distributions, (2) acceleration of benefits, (3) elections, or if the plan is not operated in accordance with any of these three requirements.
Common Changes to Separation Pay Plans that must comply with Code Section 409A
In our experience, severance plans directed toward executives generally must be amended to comply with Section 409A. The common changes required include:
Definition of Change in Control. If a change in control is the trigger for severance payments, then the plan definition of change in control should be amended to reflect the change in control definition contained in the Proposed Regulations.
Delayed Payments for Specified Employees. Section 409A prohibits deferred compensation to be paid to "Specified Employees" until at least six (6) months after the individual becomes entitled to the payment due to separation from service. The term "Specified Employee" means, only with respect to a publicly traded employer, any employee who is (1) an officer of the employer with annual compensation greater than $135,000 (indexed for inflation), (2) a 5% owner of the employer or (3) a 1% owner of the employer having annual compensation greater than $150,000. Severance arrangements that are not exempt from Section 409A and that cover a Specified Employees must be amended to postpone commencement of severance payments for at least 6 months after termination of service.
Timeline for Executing Amendments
Although the Deferred Compensation Section 409A Final Rules are not expected to Fall 2006, they are still expected to go into effect January 2007. Thus, an amendment to bring a plan into compliance with Code Section 409A must be adopted by December 31, 2006. Failure to make these changes will cause the severance payments to become taxable as of the year in which they are no longer subject to a substantial risk of forfeiture. In addition, a 20% penalty tax on these amounts is assessed and affected employees will owe interest on these amounts at the current underpayment rate (currently 1%).