Executive Employment and Severance Pay Under Section 409A of the Internal Revenue Code
Effective generally
January 1, 2005, Congress set off a sea change in the tax treatment of “nonqualified deferred compensation” arrangements with the adoption of new Section 409A of the Internal Revenue Code. Under
409A, an arrangement provides for a “deferral of compensation” if, under its terms and the relevant facts and circumstances, a service provider such as an executive has a “legally binding right”
to compensation in one taxable year but the compensation is or may be actually or constructively received in a later taxable year. Inasmuch as this will almost always be the case in executive employment and severance agreements
(particularly those containing change-in-control protections), they generally will be subject to 409A. If an executive’s employment or severance agreement is subject to 409A but not compliant in writing and in operation
by January 1, 2008, his or her severance pay and benefits may be includible in gross income before they are actually received. To add insult to injury, these amounts may also be subject to an additional tax equal to 20% of the accelerated income and possibly interest.
What severance payments escape 409A?
Certain payments escape the reach of 409A regulation altogether. For example, payments that must be made within 2½ months after the end of the year during which the right to the payment vests (the later of the year of the
executive or the company) may escape coverage under 409A under the so-called “short-term deferral rule.”
Also, severance payments are exempt from 409A to the extent they provide for the payment incident to an involuntary separation from service (including certain terminations for “good reason”) or a voluntary
termination during a 409A compliant “window period” if (1) the aggregate severance payments are less than two times the lesser of the qualified plan compensation limit (2 x $225,000 = $450,000
in 2007) for the year of termination or the executive’s prior year compensation, and (2) the severance is paid within two years following the end of the year in which the separation occurs.
Generally, under a safe harbor provision offered by the final 409A regulations, “good reason” is limited to a material diminution in base compensation; material diminution in authority, duties or responsibilities; material
diminution in the budget under the employee’s control; material change in geographic location of the employee’s work; or material breach by the employer of the terms of the employment agreement. In addition, the
safe harbor good reason clause must contain a notice and opportunity to cure and provide an equivalent amount of severance as in an involuntary termination. Alternatively, the final regulations also contain a facts and circumstances
test in determining whether a good reason clause is 409A compliant.
What severance pay must comply with 409A?
Many executive employment agreements provide for severance pay beyond the period permitted under the short-term deferral rule and/or at a time which does not constitute one of the permissible payment events provided for under 409A,
e.g. incident to a change in control event that is not 409A compliant. In addition, where there is an involuntary termination (including certain terminations “for good reason”) or a voluntary termination during
a 409A compliant window period, severance paid in excess of the “two times” pay limits is subject to 409A. Accordingly, unless amended to address 409A requirements, employment and severance agreements may violate
the new 409A rules, triggering the harsh tax consequences described above. Moreover, except in limited circumstances, the 409A rules generally apply regardless of whether an agreement was entered into before or after the January
1, 2005 effective date of 409A.
Are officers of public companies subject to additional requirements?
Payments to the top officers of public companies -- domestic and foreign -- that do not satisfy the short-term deferral rule, are in excess of the “two times” pay limits for involuntary and voluntary
terminations, or do not meet the reimbursement requirements (discussed below), are subject to a 6-month delay. That is to say, unless an exception applies, to avoid the harsh tax consequences described above, the top officers
of public companies (generally the 50 highest paid officers) must delay the receipt of their severance pay and benefits until 6 months after they separate from service (“6-month delay rule”) or, if
earlier, upon their death. Many, if not most employment and severance agreements for the top paid officers of public companies will need to be revised to either fit within a 409A exemption or to delay payment until 6 months after separation from service.
What employee benefits and reimbursements paid after separation from service escape 409A?
Many employment and severance agreements provide for certain expense reimbursements and continuation of welfare benefits coverage following separation from service. How such arrangements may continue without running afoul of
409A also has been limited. The limits generally require that reimbursements and benefits be objectively determinable and be made over an objectively prescribed period of time.
The following common severance benefits and reimbursement payments are not deferred compensation for purposes of 409A to the extent provided for a “limited period of time:”
- Continuation of health insurance coverage, whether or not taxable, for the duration of the COBRA continuation period.
- Reimbursement of expenses which the service recipient could otherwise deduct as business expenses incurred in connection with the performance of services.
- Reimbursement of reasonable outplacement or moving expenses directly related to the termination of services including the reimbursement of all or part of any loss incurred due to the sale of a primary residence.
- Reimbursement of medical expenses otherwise deductible under Section 213 of the Code (without regard to the 7.5% of adjusted gross income limitation).
- de minimis amounts, defined as aggregating under $15,500 per annum for 2007 (subject to adjustment for inflation), e.g., estate planning or tax-preparation assistance.
For purposes of the above, a limited period of time generally means for 2-3 years depending on when separation from service occurs within the calendar year.
What benefits and reimbursements must comply with 409A?
Benefits and reimbursements not meeting the prescribed exceptions above and/or provided after the limited period of time defined above must comply with 409A.
Bottom Line: To avoid the adverse tax consequences that can flow out of noncompliance with 409A, companies and executives with employment and/or severance agreements should have these agreements reviewed and revised in consultation with their companies’ compensation committee or board of directors before December 31, 2007. To assist with a review of an employment or severance agreement or for more information regarding Section 409A and the final regulations, please contact any attorney in the Troutman Sanders LLP Compensation and Employee Benefits Practice Group.