Separation Pay and IRC Section 409A: A Little Planning Can Go a Long Way
Deferred compensation, which is often an element of a severance package, can have unanticipated tax implications. Particular attention should be paid to draft and operate the deferred compensation plan so that it will be consistent with Internal Revenue Code Section 409A (section 409A) and the Final Regulations thereunder, either by complying with the rules of section 409A or by meeting an exception to section 409A. Section 409A applies generally to all nonqualified plans1 that provide for the deferral of compensation. Under the Final Regulations, a plan generally provides for the deferral of compensation if, under the plan, a service provider (such as an employee) has a legally enforceable right to compensation during a taxable year that is or may be payable in a later taxable year. Many plans that provide for separation pay may fall within this broad definition of a nonqualified deferred compensation plan, which can have severe tax consequences for the service provider if the plan violates the rules under section 409A.
If the Plan Is Subject to Section 409A
If the plan is subject to section 409A, it must be both written and operated in compliance with the section 409A rules. Generally, section 409A requires (i) distributions occur only upon specified permissible payment events, including separation from service, (ii) no acceleration of distributions is allowed, except as provided by the Final Regulations, and (iii) qualified deferral elections. Distributions to key employees of public companies from plans subject to Section 409A must be delayed for at least six months after separation from service. If the rules are violated, the service provider is subject to (i) income tax on the amount deferred for the current year and all prior years in which the amount was not subject to a substantial risk of forfeiture, (ii) a penalty tax of 20 percent of the amount deferred, and (iii) interest at 1 percent over the underpayment rate starting from the date the amount was not subject to a substantial risk of forfeiture.
To avoid the difficulty of continually ensuring that the plan is written and operated in compliance with section 409A, many plans are written specifically to be within either a short term deferral or a separation pay plan exception to section 409A.
Short-Term Deferral Exception
The “short-term deferral exception” excludes from compliance with section 409A compensation that is paid within 2½ months of the end of the service provider’s (or service recipient’s) taxable year in which the compensation was first no longer subject to a substantial risk of forfeiture. This exception is most likely to apply to separation pay agreements that are executed close to the time of the separation from service where the payments are made within a short time of separation.
Separation Pay Plan Exception
The “separation pay plan exception” applies only to involuntary or “good cause” separations or separations as part of a window program. The amount of the payments under the plan cannot exceed the lesser of two times (i) the individual’s annualized compensation from the tax year preceding the year of separation, or (ii) the qualified plan compensation limit ($245,000 in 2009). All payments under the plan must be made no later than December 31 of the second calendar year following the year of termination. The separation pay plan exception is often referred to as the “two years, two times rule” due to these limitations. The separation pay plan exception applies only to compensation that is conditioned on separation from service and does not apply to compensation the service provider could receive without separating.
The Final Regulations contain a safe harbor under which certain “good reason” separations will be treated as involuntary separations, if the separation occurs within two years of the existence of one or more specified conditions. The full list of the good reason conditions within the safe harbor can be found in Treas. Reg. section 1.409A-1(n)(2)(ii)(A). The service provider must provide notice within 90 days of the existence of one or more conditions to the service recipient, who then must have at least 30 days to cure the condition. Also, the amount, time and form of the payment upon the “good reason” separation must be substantially the same as those for employer-initiated involuntary terminations.
Conclusion and Recommendations
When drafting agreements or plans that provide for separation pay, attention should be paid to whether the plan will be subject to section 409A or will be written to fall within an exception. If the plan is subject to section 409A, it must be written and operated fully in compliance with the Final Regulations. The penalties for any violations of the section 409A rules are severe. Consider whether the plan could be drafted to fall within either the short term deferral exception or separation pay plan. If the plan is designed to fall within the separation pay plan exception and will provide for payments upon “good reason” terminations, consider using the safe harbor within the Regulations for additional assurance that the “good reason” termination will be treated as an involuntary separation by the IRS.
Amber K. Quintal, M.B.A., J.D., LL.M. is an associate in the Business Department at Ogden Murphy Wallace, P.L.L.C. in Seattle, Washington. Her practice includes federal, state and local tax, general business, estate planning and probate. She is the Chair of the WSBA Tax Section CLE Committee, and a member of the WSBA Tax Council, ABA Taxation Section and ABA Tax Section’s Young Lawyers Forum. She can be reached at firstname.lastname@example.org.
Originally published in the September 2009 issue of the King County Bar Association Bar Bulletin. Reprinted with permission of the King County Bar Association.
1. A severance package would generally be a “nonqualified plan.” A “qualified plan” is a plan that qualifies under ERISA, such as an IRA or a 401(k).
© Copyright 2009, American Bar Association.