United States: Severance Pay Arrangements May Be Affected by New Deferred Compensation Rules

On October 22, 2004, the American Jobs Creation Act of 2004 was signed into law. This legislation added Section 409A to the Internal Revenue Code, fundamentally changing the tax treatment of deferred compensation plans, including certain severance pay plans and agreements. The new rules, which are generally effective for severance payments made on or after January 1, 2005, are complicated and confusing. The Internal Revenue Service and Treasury Department have provided some guidance as to the interpretation and application of the new rules, and proposed regulations were recently issued. However, many unanswered questions still remain, and the proposed regulations may differ from the final regulations that are ultimately issued.

Under 409A, amounts deferred under a deferred compensation plan or arrangement will be includable in an employee’s income unless (a) the amounts are subject to a substantial risk of forfeiture, or (b) the plan or arrangement satisfies certain requirements. Failure to comply with the new rules may result in substantial penalties for employees covered by deferred compensation plans. Covered employees may be liable for (1) income taxes on all amounts deferred in the current and prior years, (2) interest on the tax from the date the amount was first deferred or vested and (3) additional penalties equal to 20 percent of the deferred amounts included in the employee’s income.

Distributions from a deferred compensation plan are only permitted upon (a) a participant’s separation from service, (b) a participant’s disability, (c) a participant’s death, (d) a specified time, (e) a change in control, or (f) the occurrence of an unforeseen emergency. The Act further provides that a deferred compensation arrangement cannot be amended to accelerate payments or to provide discretionary distributions, and there are limitations on an employee’s ability to make changes to an election.

With respect to separation payments available to an employee upon a voluntary termination of employment, there is no substantive distinction between a plan labeled as a severance pay plan and a nonqualified deferred compensation plan. However, many severance pay plans and agreements are unaffected by 409A because they do not provide deferred compensation. If, as is often the case, the company has the right to amend or revoke the arrangement at any time, the employee does not have a legally binding right to the payment until the payment actually occurs. There is no deferred compensation if all amounts are paid in the same year that the employee terminates employment.

However, if the employee is in a position of "control" within the company, the employee is deemed to have the right to receive the employee’s separation pay, and such separation plan or arrangement is covered by Section 409A. Generally, this means that unless one of the exceptions set forth below is met, a plan or agreement with a "controlling person" must comply with the provisions of Section 409A.

It should be noted that for severance pay plans or arrangements that are subject to 409A (notwithstanding the restrictions as to the timing of the employee’s deferral elections contained in the general provisions of 409A), the proposed regulations provide that if the severance payments are subject to bona fide arms-length negotiations at the time of termination of employment, the employee may make an initial deferral election as to the time and form of payment. This election can be done at any time prior to the time the employee has a legally binding right to the payment.

Also, the proposed regulations establish severance pay plans as a separate type of deferred compensation plan, so that a severance pay plan or arrangement that violates 409A will not "taint" the benefits payable under other types of deferred compensation plans.

Under the proposed regulations, certain severance pay plans and arrangements that would otherwise be subject to 409A can be structured in such a way as to avoid having to comply with the 409A rules. The following types of plans and arrangements are not subject to 409A:

Payments on account of involuntary termination or pursuant to an early retirement "window" For a severance plan or arrangement to qualify for this exception from the 409A rules, the payments must be a result of the involuntary termination of the employee’s employment by the company or the employee’s participation in an early retirement "window program." A window program is defined as an early retirement program under which employees are given incentives to leave during a limited time period. The plan or arrangement must either be collectively bargained, or the payments must (a) not exceed the lesser of two times the employee’s compensation for the year prior to the employee’s termination of employment or two times the compensation limit applicable to qualified plans ($210,000 for 2005) and (b) be completed by the end of the second calendar year following the employee’s termination of employment. In order to qualify for this exclusion, the severance payments must not be a substitute or replacement for amounts otherwise deferred.

This exception is particularly significant to key employees of public companies because payments of their separation pay will not be subject to a six-month delay.

Certain expense reimbursement arrangements Severance agreements which provide for certain expense reimbursements and meet certain timing requirements are not subject to the provisions of 409A. Such agreements may provide for reimbursements that are otherwise excludable from gross income, including reimbursements for expenses the company can deduct as business expenses, reasonable outplacement expenses, reasonable moving expenses, medical expenses and certain other expenses that do not exceed $5,000 in the aggregate. The reimbursements must be paid to the employee by the end of the second calendar year following the calendar year of the employee’s termination of employment.

Severance arrangements which meet the short-term deferral rules Severance arrangements which provide for payments to an employee in the event of an involuntary termination of employment are excluded from the requirements of 409A if the arrangements provide for full payment of the severance benefits within 2½ months after the end of the calendar year in which the severance benefits became nonforfeitable.

All severance plans and arrangements and employment agreements containing severance provisions should be reviewed carefully to determine if amendments are necessary, either to comply with the requirements of 409A or to meet one of the exceptions.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.