Employee Benefits Law Alert: Severance Provisions in the Section 409A Proposed Regulations
1/1/2006

Section 409A, which was added to the Internal Revenue Code in October 2004, imposes onerous penalties on nonqualified deferred compensation that fails to meet strict new rules. Although Congress enacted Section 409A in response to well-publicized abuses by highly paid public company executives, the broad scope of the legislation will have a wide-ranging impact on compensation generally, including employment agreements and severance arrangements for employees, officers, directors and consultants of public and private companies.

The Internal Revenue Service (IRS) has provided preliminary guidance regarding Section 409A in Notices 2005-1 and 2006-4 and in proposed regulations issued in September 2005. This Client Alert highlights the severance provisions in the proposed regulations, and is one of a series of Client Alerts prepared by Stoel Rives LLP that explain the substantive provisions of the proposed regulations. Links to the other Client Alerts are provided at the end of this Alert.

Section 409A Overview

Section 409A operates by specifying the nonqualified deferred compensation arrangements that are subject to its rules and by setting out detailed rules that must be satisfied with respect to (1) the timing of elections to defer compensation and (2) the timing of distributions of amounts treated as deferred. To the extent these rules are not met, Section 409A taxes compensation earlier than pre-Section 409A rules (generally at the time of vesting rather than at the time of payment) and imposes an additional twenty percent penalty tax on the amount included in income and an additional interest charge on amounts deferred at the IRS's interest rate for underpayments, plus one percent.

As a result, Section 409A requires companies to determine whether a particular compensation arrangement is nonqualified deferred compensation covered by Section 409A, and if so, what deferral elections and distribution events must be followed to avoid the acceleration of tax and penalty taxes imposed on arrangements that do not comply with Section 409A.

Separation Pay Exception

The proposed regulations confirm that severance plans generally are subject to Section 409A, even those that cover only rank-and-file employees or provide for payments only on an involuntary separation from service. However, plans that (1) pay benefits only on an involuntary separation or pursuant to a voluntary window program, and (2) meet either of the following conditions are not subject to Section 409A:

• The plan is collectively bargained; or

• The plan provides that the amount of severance benefits payable under the plan does not exceed two times the lesser of (i) the employee's annual compensation for the prior calendar year or (ii) the Section 401(a)(17) limit applicable to qualified retirement plans ($220,000 for 2006), and that all payments must be made by the end of the second calendar year following the year in which separation occurs.

Exemption for Certain Reimbursements. In addition, the regulations also exempt certain reimbursement arrangements related to a separation from service (e.g., reasonable outplacement services, moving expenses, continued medical coverage, etc.) from Section 409A, but only to the extent the expenses are incurred and reimbursed before the end of the second calendar year following the calendar year in which separation occurs.

Short-Term Deferral Exception

Severance arrangements that do not meet the separation pay exception may still be exempt from Section 409A if benefits are fully paid out to the departing employee by March 15th of the calendar year following the calendar year during which the benefits first become vested (i.e., are no longer subject to a substantial risk of forfeiture). The severance arrangement need not expressly provide for payment within this time period. It is enough if the payment is actually made within the time limit. However, if the arrangement does provide a set date for payment by March 15 (or, if later, 2-½ months after the close of the employer's fiscal year in which the benefits vested), and payment is not made by that date, then later payment will still be deemed to satisfy Section 409A, as long as payment is made within the same calendar year as the set payment date or, if later, by the 15th day of the third month following the month in which the payment was scheduled to be made.

The proposed regulations treat the right to payments on an involuntary separation as a nonvested right. However, the right to payments on a voluntary separation is treated as a vested right. This rule allows employers to structure involuntary severance arrangements to meet the requirements of the short-term deferral exception. By contrast, a voluntary severance arrangement generally must be set up to comply with Section 409A's rules regarding the time and form of payment, including the rule that requires a six-month delay on payments to specified employees of public companies (discussed below).

"Good Reason" Resignations. Although severance benefits payable on a voluntary separation from service generally must comply with Section 409A's rules regarding the time and form of payment, it remains unclear whether the short-term deferral exception may apply to benefits payable on a resignation for "good reason." The IRS's informal position to date has been that "good reason" provisions are problematic under Section 409A. Employers should wait until final regulations are issued before revising severance arrangements that rely on "good reason" definitions.

Severance Benefits Payable on Involuntary Termination "Without Cause" or Voluntary Termination "With Good Reason." This same caution applies to a severance arrangement that provides for payment of benefits upon either an involuntary separation "without cause" or a voluntary separation "with good reason" (a common design in executive employment and severance agreements). Under such an arrangement, the severance benefits may be subject to Section 409A, even if ultimately paid on an involuntary separation that would otherwise fit within the separation pay exception or the short-term deferral exception. If Section 409A applies, the severance arrangement would need to comply with Section 409A's rules regarding the time and form of payment, including the six-month delay on payments to specified employees of public companies (discussed below). Employers should wait until final regulations are issued before revising their agreements with regard to these provisions.

Six-Month Delay for Specified Employees

Section 409A requires that nonqualified deferred compensation payable on separation from service to "specified employees" (generally defined as officers, five percent owners or certain one percent owners of the employer who are treated as key employees under the top-heavy rules that apply to tax-qualified retirement plans) of public companies on a separation from service not be paid until six months after the separation date. As a result, public companies will need to amend their employment and severance agreements to provide for this six-month delay, unless the arrangement is otherwise exempt from Section 409A. In amending arrangements, companies will need to make clear how the six-month delay will be implemented—i.e., will all payments be delayed for six months, or will the amounts otherwise payable during the six-month period be paid in a lump sum on a fixed date following expiration of the six-month period.

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This Client Alert is a brief summary of certain of the provisions of the proposed regulations. In the interest of brevity, many details and issues have been omitted. If you have any questions or would like more information, please telephone one of the following attorneys:

Client Alert: Treasury and IRS Issue New Proposed Regulations Regarding Deferred Compensation Plans

Client Alert: Overview of Key Provisions of the Section 409A Proposed Regulations

Client Alert: Equity Compensation Provisions in the Section 409A Proposed Regulations

IRS Circular 230 Notice: Any tax advice contained herein was not intended or written to be used, and cannot be used, by you or any other person (i) in promoting, marketing or recommending any transaction, plan or arrangement, or (ii) for the purpose of avoiding penalties that may be imposed under federal tax law.