Applying Code Section 409A To Severance Agreements Or Not?
Ten years ago, the passage of Internal Revenue Code Section 409A significantly changed the rules relating to non-qualified deferred compensation arrangements. This includes how we look at severance agreements. In general terms, Section 409A applies to compensation or in-kind benefits which are earned in one year for services rendered and are paid in a later year. Severance agreements or separation pay plans are either subject to Section 409A or are exempt from Section 409A. If a severance agreement is exempt from Section 409A, then the agreement does not have to comply with all of the technical requirements of Section 409A including definitions of key terms, timing and form of distribution, etc. The agreement and the administration of the agreement will also be exempt from any Section 409A tax penalties associated with noncompliance.
To avoid Section 409A in a severance agreement, you must meet one of the enumerated exemptions. The four basic exemptions from Section 409A for severance agreements are: (1) collectively bargained plans; (2) involuntary separation or voluntary separation in a window program; (3) certain foreign plans; and, (4) certain reimbursements or in-kind benefits in voluntary or involuntary separation from service. There are several other exemptions that may also apply to allow severance agreements to be outside the parameters of Section 409A. These include a catch-all exemption for separation from service payments that do not exceed the deferral limit under Code Section 402(g). This Section 402(g) limit is the salary deferral limit in 401(k) plans, which for 2015 is $18,000. Another exception that may apply is the so-called “short-term deferral” exception. If compensation is paid within the first two and a half months in the year following the year of termination of employment, the payments are not subject to Section 409A or its regulatory requirements.
In looking at a separation agreement, the separation pay exception will not apply to amounts that are a substitute for any deferred compensation that would otherwise be payable under a prior deferred compensation plan. This is a facts and circumstances analysis, but, simply, if there was a prior deferred compensation plan in place and termination of employment occurs, and if the payment is similar to what was payable under the former deferred compensation plan, the payment after termination of employment will be considered based on the prior plan and will not qualify for any of the severance agreement exceptions to Section 409A.
The exception to Section 409A for involuntary separation or for separation in a window retirement program means that the severance agreement will not be subject to Section 409A if: (1) the amount paid does not exceed the lesser of twice the annual salary of the affected employee or the compensation limit under 401(k) plans, which in 2015 is $265,000; and, (2) the severance payments will not extend beyond two years from the date of termination. This exception with its two-year limit on payments corresponds with the Department of Labor regulations which provide that if severance plan payments exceed two years of payments from the date of termination, the severance plan will be a pension plan subject to ERISA and all of its rules.
An early retirement window program provides incentives to certain employees to retire voluntarily and ahead of their normal retirement. A window program is an offering to certain employees during a limited period of time, which may not exceed twelve months. The window program can allow the select employees to elect a lump sum payout or installment payments up to two years. The constructive receipt rules must be complied with, which means the lump sum payment or the installment payments may not be currently available to the employees. The lump sum payout may be conditioned on a waiver of a right to subsidized retiree health benefits.
For publicly-traded companies, when there is an involuntary termination and the affected employee is a “specified employee” (which is similar to a key employee) there is a six-month required delay in the distribution of any severance pay after separation from service. This six-month delay may cause a hardship to the key employee after separation of employment. Of course, if the severance agreement fits under one of the exceptions to Section 409A, then the severance payments may begin immediately upon termination of employment with no six-month waiting period. However, if none of the exceptions to Section 409A apply, then the severance agreement in a publicly-traded company will be subject to Section 409A and the specified employee must wait six months after the termination of employment for the severance payments to begin. One option in this situation is to use the short-term deferral exception for an easy payment to make up for the six-month delay.
The exception for reimbursements and in-kind benefits means that if reimbursement expenses or in-kind benefits are provided as part of a severance agreement, these payments are excluded from Section 409A if they are the type of expenses that would normally be included in income under Code Section 162 or 167. For example, in either a voluntary or involuntary separation from employment, if reasonable moving expenses, medical expenses, office space usage, use of company cars, or airplanes are reimbursed as part of the severance package, these reimbursements are excluded from the requirements under Section 409A if incurred within a two-year period after termination of employment. The reimbursement expenses must be paid by the company before the end of the third year following termination of employment. One caveat is if medical expenses are reimbursed, the medical expenses are limited to the COBRA period (typically 18 months) that applies to the affected employee.
Typically, a severance agreement is going to require a release of claims to be signed and not revoked by the terminating employee. If a severance agreement is covered by Section 409A, a specific date for the payment of severance or the beginning date of the severance payments must be provided in the agreement. The agreement must state the time by which the release must be signed in a manner that satisfies Section 409A. For example, the severance agreement may state severance payments will begin on a fixed date, subject to the employee signing and not rescinding the release before that date. To determine a fixed date, you must consider the time period that the employee must be given to consider a release before signing and not revoking the release. If a severance agreement falls within one of the exceptions to Section 409A, then the timing of signing of a release and payment following the revocation period of a release is not an issue.
Under the Older Workers Benefit Protection Act, an employee must have 21 days (45 days in certain circumstances) to review a release and 7 days to revoke it. Since Section 409A requires a specific date upon which payment can be made in order to comply with Section 409A, a severance agreement could provide that the employee who is required to sign a release could receive severance on the 60th day following termination of employment. This means that if the employee is given the release on the date of termination, there would be enough time for the employee to consider the release and for the revocation period to end before the fixed payment date upon which the severance payment would be made or begin to be made.
The practical problem with the fixed date requirement under Section 409A is that an employee must wait until the fixed date to begin receiving her severance even if she signs the release early. Section 409A does allow for payment to be made up to 30 days before the date specified in the severance agreement without causing a violation of Section 409A. One item to keep in mind is that the affected employee may not specify or be able to determine the year of payment for the severance.
One other approach to proper timing for a release of claims is that the agreement can provide that the release must be signed during a window period. This window period must be no more than 90 days after termination of employment under Section 409A. During this window period, the release revocation period will expire. In a window approach, the severance agreement should provide that if the payment window spans two calendar years, then the payment of severance will be made in the second year. This eliminates any employee discretion. If there are installment payments, the employee may receive a catchup payment of any installment for the period between the termination date, the day the revocation expires, and the actual payment date. The fixed date approach and the window period approach only apply if the severance payments are subject to Section 409A. If the severance is paid by March 15 of the year following the year of termination of employment, the short-term deferral is met and the severance agreement does not need to comply with Section 409A. Of course, the agreement will need to comply with the signing of the release and the revocation period that applies.
In short, severance agreements need to either comply with Code Section 409A or meet one of the exemptions under Section 409A. Meeting one of the exemptions, once you know the rules, seems preferable to both the company and the terminating employee. If you have any questions or need any assistance in figuring out if a severance plan complies with Code Section 409A or is exempt from it, please give us a call.