- Section 409A Countdown to Full Compliance -- Installment No. 3
- May 9, 2007 | Authors: Jeffrey R. Capwell; Robert M. Cipolla; Steven D. Kittrell; James P. McElligott; Kimberly J. Boggs; G. William Tysse
- Law Firms: McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Richmond Office ; McGuireWoods LLP - Washington Office ; McGuireWoods LLP - Richmond Office ; McGuireWoods LLP - Chicago Office ; McGuireWoods LLP - Richmond Office ; McGuireWoods LLP - Chicago Office ; McGuireWoods LLP - Washington Office
Section 409A Rewrites the Rules on Severance Pay and Benefits
This is the third in a series of articles addressing significant issues under the new Internal Revenue Code Section 409A rules for taxing “non-qualified deferred compensation.” In this installment we analyze the impact of Section 409A on severance pay and benefits – what the Internal Revenue Service calls “separation pay arrangements.”
Section 409A has a significant impact on the design and operation of severance pay and benefits. In light of the December 31, 2007 full compliance deadline, employers should review in the next few months all of their contracts, policies and benefit plans to be sure that their separation pay practices will either qualify for an exemption from Section 409A or will otherwise be brought into full compliance with Section 409A by that deadline.
We will discuss separation pay in the context of employer/employee relationships, but keep in mind that many types of non-employee service providers may also be subject to these rules, including corporate directors.
Section 409A Applies to Separation Pay Unless a Specific Exemption Applies
Section 409A applies to any separation pay arrangement in which an employee acquires a legally binding right to payments from his employer in the event the employee is terminated, unless such arrangement is specifically exempted under Section 409A. The IRS considers an employee to have a “legally binding right” to separation pay even though that right is contingent on the future event of termination of employment. Deferred compensation is not limited solely to direct cash payments, but can also include amounts paid as reimbursement of expenses or the employer’s provision of in-kind services.
Example: Executive’s Employer promises to pay severance to the Executive in the event the Executive is terminated without cause in the future. Unless one of the exemptions discussed below applies, the IRS considers this “non-qualified deferred compensation” and this promise must comply with the requirements of Section 409A. To comply with Section 409A, the promise would need to be evidenced in a written agreement or other written documents that contained the provisions required under Section 409A. In addition, the severance promise would need to be administered in compliance with Section 409A.
Example: Executive has no legally binding right to severance, but Employer pays severance to Executive when Executive’s employment is terminated in the same taxable year. There is no deferral of compensation and Section 409A does not apply.
Example: Employer agrees to reimburse Executive’s country club dues and provide use of the Employer’s plane for fives years following Executive’s termination. These amounts are non-qualified deferred compensation and must comply with Section 409A in the manner noted above.
Under Section 409A, “non-qualified deferred compensation” can exist in ERISA severance plans, employment contracts, supplemental executive retirement plans (“SERPs”), and nearly any other arrangement, including informal practices or policies that result in a deferral of compensation.
Fortunately, many commonly used separation pay arrangements may qualify for an exemption from Section 409A. The following forms of separation pay are exempted from Section 409A rules:
- Involuntary separation where all amounts are paid within 2½ months after the end of the year in which the employee is involuntarily terminated (“short-term deferral period”). When calculating the short-term deferral period, the later of either the employee’s taxable year or the employer’s taxable year may be used. The employee’s taxable year is generally the calendar year.
- Certain bona fide collectively bargained arrangements,
- Certain arrangements providing separation pay due solely to an involuntary separation from service or participation in a window program in limited amounts and for a limited period of time,
- Certain foreign separation pay arrangements,
- Certain reimbursement arrangements providing for expense reimbursements or in-kind benefits for a limited period of time following a separation from service, and
- Certain rights to limited amounts of separation pay.
Employers must understand these exemptions and be alert for separation arrangements that fall outside these exemptions – many of which involve separation pay of highly compensated executives. If a separation pay arrangement is not exempted from Section 409A, it must comply with Section 409A’s substantive requirements, such as its payment timing requirements.
Separation Pay Arrangements Exempt from Section 409A
Involuntary Separations With All Payments Made Within Short-term Deferral Period
A separation pay arrangement is exempt from Section 409A if all amounts under the arrangement can only be paid within 2½ months after the end of the year in which the amount was no longer subject to a substantial risk of forfeiture. For involuntary separations, an amount is no longer subject to a substantial risk of forfeiture once the employee is involuntarily terminated. In contrast, severance amounts that are payable upon any voluntary separation from service (whether or not the amounts are actually paid upon a voluntary separation) are not subject to a substantial risk of forfeiture as soon as the arrangement is entered into and before the employee actually terminates.
Severance payments triggered by a voluntary separation may nevertheless be exempt from Section 409A if the employee does not have a legally binding right to the severance pay (such as where the employer has an unfettered right to eliminate the severance benefit at any time), or if all payments are completed within 2½ months after the end of the year in which the employee first acquired a legally binding right to the payments. However, special care needs to be exercised when relying on the “no legally binding right” exception since a condition on the employer’s discretion to eliminate a severance promise generally will not be sufficient to prevent a legally binding right from arising. In addition, the IRS has indicated that a legally binding right exists where the employer reserves discretion to eliminate the promise if such discretion “lacks substantive significance.” Finally, an employer’s discretion to reduce or eliminate severance pay will not be recognized where the employee has effective control of the employer, such as may exist in a family-controlled business.
Involuntary Separation with Limited Payments over Limited Time
If a separation pay arrangement only provides for payments upon an involuntary termination of employment and the payments extend beyond the short-term deferral period, the severance payments are nevertheless exempt to the extent that:
- all payments are made by the end of the second year following the year in which the involuntary termination occurs, and
- the total amount of payments does not exceed two times the lesser of (1) the employee’s annual compensation for the calendar year preceding the calendar year in which termination occurs (adjusted for any permanent increases in compensation for the year in which the termination occurs) or (2) the limit on compensation under Internal Revenue Code Section 401(a)(17) for the calendar year in which termination occurs (the limit under Code Section 401(a)(17) is $225,000 for 2007).
The final regulations clarify that employees can use this exclusion up to the amount that payments do not exceed two times the employee’s annual compensation or two times the Section 401(a)(17) limit. Thus, if a severance arrangement satisfies each condition of this exemption except for the dollar amount ceiling, the exemption from Section 409A will apply to the amount that was within the permissible limit.
Window Programs and Resignations for Good Reason May be Involuntary Separations
Certain terminations, including window program terminations and good reason resignations, are treated as involuntary terminations for the purpose of Section 409A.
A window program is as an employer-established program that provides severance pay in connection with a termination of employment, for a limited period of time (no greater than one year), for employees who terminate employment during that period or who terminate employment during that period under specified circumstances.
Generally, a good reason separation is treated as an involuntary termination when the employee voluntarily terminates his services following an event that constitutes good reason for resignation. The final regulations state that good reason requires a material negative change in the employment relationship, such as a material negative change in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. A separation from employment will not be considered a good reason termination if the employer’s purpose was avoidance of Section 409A.
The final regulations create a safe harbor for good reason resignations. To take advantage of this safe harbor, the amount, time and form of payment upon a voluntary good reason separation must be identical to the amount, time and form of payment upon an involuntary separation from service. The plan must make such amounts payable only if the good reason resignation occurs no later than one year following the existence of the condition giving rise to good reason. Also, the plan must require the employee to provide notice of the existence of the good reason condition within a period not to exceed 90 days of its initial existence, and the employer must be provided a period of at least 30 days during which it may remedy the good reason condition. The safe harbor good reason conditions are:
- a material diminution in the employee’s base compensation;
- a material diminution in the employee’s authority, duties, or responsibilities;
- a material diminution in the authority, duties, or responsibilities of the supervisor to whom the employee is required to report, including a requirement that a employee report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation (or similar entity with respect to an entity other than a corporation);
- a material diminution in the budget over which the employee retains authority;
- a material change in geographic location at which the employee must perform the services; or
- any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.
Compliance Tip: The safe harbor provided in the final regulations is similar in many respects to the good reason termination provisions that commonly have been in use. Employers that wish to have comfort that a good reason termination event will be treated as an involuntary termination should consider putting the safe harbor definition into their employment and change in control agreements, severance pay plans and other severance arrangements.
Exemption for Collectively Bargained Separation Pay Plans
A separation pay plan does not provide for a deferral of compensation under Section 409A to the extent the plan is a bona fide collectively bargained separation pay plan that provides for separation pay only upon an involuntary separation from service or pursuant to a window program. Such plans are exempt from Section 409A.
Excludable Benefits Are Not Deferred Compensation Under Section 409A
If a benefit provided under a separation pay arrangement would be excludible from the employee’s income, it will not be treated as a deferral of compensation under Section 409A. Therefore, an agreement to provide fully-insured health coverage after termination of employment would not be subject to Section 409A to the extent such coverage is not taxable to the former employee.
Limited Exemption for Non-Excludable Reimbursements of Expenses and Receipt of In-Kind Services
Certain types of non-excludable reimbursement arrangements commonly found in severance plans are exempt from Section 409A if reimbursement is made for expenses incurred (or in-kind services are provided) before the end of the second year after the year in which termination occurs. The final Section 409A regulations exempt non-excludable reimbursement of expenses (and in-kind services provided) such as reasonable moving expenses, reasonable outplacement expenses, and the employee’s deductible business expenses for a limited period, directly related to a separation from service, whether voluntary or involuntary. The expenses must be incurred (and the in-kind services provided) before the end of the second taxable year following the separation from service. The period during which reimbursements for such expenses must be paid may not extend beyond the third taxable year of the employee following the taxable year in which the separation from service occurred. The regulations state that the reimbursement of reasonable moving expenses includes the reimbursement of all or part of any loss the service provider actually incurs due to the sale of a primary residence in connection with a separation from service. The regulations also exempt non-excludable reimbursements of medical expenses provided during the employee’s COBRA period.
Reimbursements and in-kind benefits provided after separation that do not fall within the exemptions described above are not exempted from Section 409A, but the final regulations offer guidance on structuring those arrangements to enable compliance.
Separation Pay Required by Foreign Law
Under 409A regulations, separation pay required to be provided under the law of a foreign jurisdiction does not provide for deferred compensation, whether or not the separation was involuntary. Generally this applies only to applicable foreign earned income.
Separation Pay in Court Awards and Legal Settlements
Court awards and amounts paid pursuant to a bona fide settlement of employment related litigation between an employer and employee are generally not subject to Section 409A.
The regulations recognize that an agreement does not provide for a deferral of compensation under Section 409A to the extent that the agreement settles bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or worker's compensation statutes, including claims under applicable Federal, state, local, or foreign laws, or for reimbursements or payments of reasonable attorneys fees or other reasonable expenses incurred related to such bona fide legal claims, regardless of whether such settlements, awards, or reimbursement or payment of expenses pursuant to such claims are treated as compensation or wages for Federal tax purposes.
However, the regulations explain that, unless another exemption applies, amounts payable upon separation from employment but conditioned on the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirements are subject to Section 409A.
The IRS will consider the facts and circumstances to determine whether the waiver of claims is a settlement of a bona fide claim. This does not apply to any deferred amounts that did not arise as a result of a bona fide claim for damages, such as amounts that would have been deferred or paid regardless of the existence of such claim, even if those amounts are paid or modified as part of a settlement resolving a bona fide claim.
Educational Assistance as Separation Pay
Benefits consisting of educational assistance provided solely to the employee are not subject to 409A. But, promises to provide educational assistance in future years to persons other than the employee, including family members and dependents, generally would be subject to Section 409A.
Other Separation Pay Not Exceeding the Elective Deferral Limit
The 409A regulations exempt, if not otherwise exempted, rights to separation payments to the extent such payments in the aggregate do not exceed the elective deferral limit for qualified retirement plans under Internal Revenue Code Section 402(g)(1)(B) for the year of the separation from service. For 2007, that amount is $15,500.
Example: A non-publicly traded company limits separation pay arrangements to involuntary terminations, window termination plans, and good reason resignations. The company’s separation packages provide 1) payment of severance within 2 ½ months of the end of the year of termination, 2) payment of COBRA premiums during the applicable COBRA period, 3) reimbursement of reasonable relocation and outplacement expenses incurred by the end of the second year following the year of termination; and 4) payment of the employee's country club membership dues or other non-excludable fringe benefits up to a limit of $10,000. This form of separation pay is exempt from Section 409A.
Under rules that will be discussed in a future article, publicly traded companies may not pay severance to certain highly paid executives earlier than six months following the executive’s termination.
Complying with Section 409A
If a separation arrangement is not exempt from Section 409A, it must comply with the timing and election requirements of Section 409A. Also, plans subject to Section 409A must be in writing.
Compliance tip: The final regulations reject the use of a so-called “savings clause,” in which the parties attempt to insulate themselves from violations of Section 409A by stating that the contract will be interpreted and administered consistent with Section 409A regardless of the agreement’s written terms. Accordingly, parties must take care to comply with Section 409A at the time of drafting.
Defining separation from service
The terms of a plan subject to Section 409A must not permit severance benefits to be distributed except upon the occurrence of certain specified events, including a separation from service. Under the final regulations, a separation from service is a death, retirement or other termination of employment. A bona fide leave (sick, military or other) is not a termination if the leave is less than six months or, if longer, less than the person’s guaranteed rehire period. If a leave with no guaranteed rehire exceeds six months, a separation from service occurs at the end of the six-month period.
A facts and circumstances test is used to determine whether a termination of employment has occurred. However, the IRS is concerned about situations in which the parties could manipulate the tax code by agreeing that a termination has or has not occurred for the improper purpose of either accelerating or deferring a payment.
If a former employee continues to provide services as an independent contractor or otherwise, there is a presumption that a termination has not occurred if the individual provides services at a rate that is 50% or more of the average services provided during the prior 3 calendar years (or total employment term if less). The presumption can be rebutted by demonstrating that, at the time of the termination, the parties reasonably anticipated that the employee's level of services would cease or permanently decrease to a rate of 20% or less of the average services provided during the prior 3 calendar years (or total employment term if less).
On the other hand, if an employee nominally continues to be an employee but provides only insignificant services, there is a presumption that a termination has occurred if the individual's level of services decreases to a level equal to or below 20% of the average rate of services for the prior 3 calendar years (or total employment term if less).
No presumption applies to a decrease in services to a level that is more than 20% but less than 50%. The final regulations allow plans to create a presumption in these circumstances by defining separations from service to include permanent reductions in services to any rate that is higher than 20% but less than 50%.
Timing of deferral election
If an employee is permitted to make a deferral election with respect to severance payments made upon a voluntary separation of service, this deferral election must be made by the end of the year before the year in which the employee acquires a legally binding right to such payments. However, where severance pay due to an involuntary termination is the subject of bona-fide, arms-length negotiations, the deferral election may be made at any time prior to the involuntary termination. A future installment of this series will focus on Section 409A’s election requirements.
Compliance tip: Under the final rules, if a terminating employee already has a right to severance, additional payments negotiated at the time of departure may be deemed an impermissible acceleration of a payment in violation of Section 409A. All parties must be aware of the unintended tax consequences these additional payments can invoke.
Fixed form and payment schedule
Moreover, a plan does not comply with Section 409A if it gives either the employee or employer discretion to modify the payment schedule. However, the final regulations allow some flexibility. For example, if a plan designates that payment must be made within the employee’s taxable year that includes December 31, 2008, it has complied with the requirement of a fixed payment schedule. Section 409A’s fixed form and payment schedule requirements will be explored in greater depth in a future installment of this series.
Special rules for public companies
Section 409A forbids a public company from paying deferred compensation to specified executives earlier than six months following the employee’s termination, unless the arrangement is otherwise exempt from Section 409A. For the purpose of Section 409A, the specified executives are identified with reference to their salary, percentage of ownership, and other factors. A later article in this series will address the rules governing identification of these executives.
Reporting and withholding obligations
For 2005 and 2006, the IRS required employers to report any Section 409A violations that occurred during those years on the employee’s W-2 statement or 1099-MISC, separately stating the amount subject to the violation and using a special code to identify that a violation has occurred. Although employers’ reporting and withholding obligations for 2007 and beyond are not addressed in the final regulations, the IRS intends to issue further guidance on these subjects. Future guidance may require employers to report all nonqualified deferred compensation and to estimate the value of future severance compensation payments (including the value of any reimbursement or tax-gross up payments) for current reporting purposes.
Consequences of Noncompliance
If a severance pay arrangement that is not exempt from Section 409A fails to comply with Section 409A, the severance payments for the covered employee become taxable as of the year in which they are no longer subject to a substantial risk of forfeiture. Also, Section 409A imposes an additional 20% penalty tax on these amounts. Finally, the employee will owe interest on these amounts at the current IRS underpayment rate plus 1%. All of the penalties fall on the employee.
Similar plans are generally aggregated for compliance purposes in accordance with the final regulations, so that a disqualification of one such plan disqualifies each other plan so aggregated. Voluntary severance plans are subject to these plan aggregation rules and are lumped together with plans of the same type, usually other account balance plans. Involuntary separation pay arrangements are treated as separate plans and are not aggregated. The plan aggregation rules applicable to Section 409A were detailed in a previous installment of this series.