On September 29, 2005, Treasury and the IRS issued proposed regulations on deferred compensation under Section 409A of the Internal Revenue Code. Section 409A governs arrangements that provide deferred compensation to employees, including severance plans (referred to in the proposed regulations as “separation pay arrangements”). However, the proposed regulations exempt certain types of severance plans from Section 409A and its requirements because they are not considered to involve a deferral of compensation.

Trucker Huss has been reviewing severance plans and drafting amendments to either take advantage of these exemptions or comply with the requirements of Section 409A before the December 31, 2006 deadline for such amendments. In general, we are finding that severance plans covering executives will not be exempt, and need to be amended to comply with Section 409A, while those covering rank and file employees may be amended to be exempt from Section 409A. In either case, the amendment process is relatively straightforward. This article discusses the exemptions applicable to severance plans, and identifies several common severance plan provisions that may cause an inadvertent violation of Section 409A.

Key Definitions and Concepts
A few definitions and concepts are crucial to an understanding of Section 409A and the proposed regulations:

A Legally Binding Right to Compensation
Deferred compensation exists only when the service provider (employee) has a legally binding right to receive compensation that is payable in a later year. A legally binding right may exist even where the right is subject to conditions or is nonvested or subject to a substantial risk of forfeiture. Conversely, a legally binding right to compensation does not exist if the compensation may be unilaterally reduced or eliminated by the service recipient (employer) after the services creating the right to compensation have been performed. Thus, in the case of a severance plan, no deferred compensation exists as long as the employer has the discretion not to provide any severance pay. However, a legally binding right may exist even if the employer’s obligation to provide severance pay is subject to a condition (i.e., termination).

Substantial Risk of Forfeiture
Compensation is considered to be subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services or the occurrence of a condition related to the purpose of the compensation, and the possibility of forfeiture is substantial. Thus, severance pay provided upon an employee’s involuntary termination is subject to a substantial risk of forfeiture. However, severance pay provided upon voluntary termination is not subject to a substantial risk of forfeiture.

Aggregation
Four categories of plans are subject to Section 409A:

• account balance plans;
• non-account balance plans;
• separation pay arrangements (i.e., severance plans); and
• all other plans.

A form or operational violation occurring with respect to a plan in one category (such as a severance plan) will trigger Section 409A tax consequences for an employee, not only for benefits under that plan but also for benefits paid under all other plans in the same category. This aggregation will not extend to the employee’s benefits paid under the other three types of plans in which the employee may also participate. Informal comments by Treasury officials suggest that the final regulations may create a new category for certain in-kind benefits and expense reimbursements received following a termination of employment.

Exemptions Applicable to Severance Plans
Certain severance payments are exempt from Section 409A and its requirements because they are not considered to involve a deferral of compensation. Severance payments upon an employee’s involuntary termination or pursuant to a window program (where a group of employees is identified as being subject to termination and those employees are provided with an incentive to voluntarily terminate) may be exempt from Section 409A under the short-term deferral rule, the “two-times” exemption, or the collective bargaining exemption. Severance plans often provide free outplacement services and employer-paid health coverage for a specified period of time. These benefits also may be exempt from Section 409A.

Involuntary Termination
Any severance payment triggered by an employee’s voluntary termination is subject to Section 409A. Severance plans, even those for top executives, usually condition payment of severance benefits on involuntary termination. However, these plans often also provide that a voluntary termination for “good reason” (such as a job transfer of more than 50 miles, a demotion, etc.) is deemed involuntary. The IRS and Treasury have taken the position that payments conditioned on “good reason” termination are not subject to a substantial risk of forfeiture. Many of the comments received by the IRS and Treasury argue that a substantial risk of forfeiture may exist in a “good reason” termination situation. Informal comments by Treasury officials suggest that their position will not change when the final regulations are published later this year. Therefore, it would be prudent to assume — as provided in the proposed regulations — that any severance plan providing benefits upon “good reason” termination is subject to Section 409A.

Short-Term Deferral Rule
Short-term deferrals are not considered deferred compensation. A payment is a short term deferral if it is actually or constructively received by the later of:

• 2½ months after the end of the employee’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or
• 2½ months after the end of the service recipient’s taxable year in which the amount is no longer subject to a substantial risk of forfeiture.

If severance payments are conditioned on involuntary termination, then the right to payment remains subject to a substantial risk of forfeiture until termination occurs. Thus, a severance payment under a plan that covers only involuntary terminations will qualify as a short-term deferral, and thereby fall outside the scope of Section 409A, if payment is made within 2½ months after the end of the year in which the employee is terminated. For example, if both the employee and employer are calendar year taxpayers, and the employee is involuntarily terminated during 2006, any severance payment made before March 15, 2007 is not subject to Section 409A.

“Two-Times” Exemption
Severance payments triggered by involuntary termination or termination during a window period are exempt from Section 409A if:

• All payments are made by December 31 of the second year following the year in which the employee terminates; and
• The amount of severance pay does not exceed the lesser of:
  • two times the employee’s annual compensation for the previous calendar year; or
  • two times the Code section 401(a)(17) limit ($210,000 for 2005) for the previous calendar year.

Except for the Section 401(a)(17) limit, this exemption nearly tracks the safe harbor contained in Department of Labor regulations under which a severance plan may be treated a welfare plan. Severance plans covering highly paid employees seeking an exemption from Section 409A generally will find the 401(a)(17) limit problematic. They should consider providing for lump sum payments only, in order to qualify for the short term deferral exemption. However, the “two times” exemption is a viable option for plans that pay severance benefits in installments to rank and file employees.

Collectively Bargained Severance Plans
If a severance plan is maintained pursuant to an agreement that qualifies as a collective bargaining agreement under Code section 7701(a)(46), payments triggered by involuntary termination or termination during a window period are not deferred compensation, so long as the severance pay was the subject of armslength bargaining between employee representatives and one or more employers and the circumstances surrounding the agreement evidence good faith bargaining between the parties over the severance pay provided under the agreement.

Reimbursements and In-Kind Benefits
Severance plans often provide for continuing employer-paid health coverage, outplacement services, and other benefits. These payments are exempt from Section 409A so long as they are provided for a “limited period of time,” defined as a period which does not extend beyond December 31 of the second calendar year following the calendar year in which employment terminates. Thus, if an employer pays for health coverage for more than 24 months following termination, these payments may be subject to Section 409A depending on the employee’s date of termination. Under the aggregation rules, if an employee’s post-termination health coverage is subject to Section 409A, all severance benefits paid to that employee would be subject to Section 409A. The final regulations may provide some relief in this area by treating in-kind benefits as a separate type of plan. If they do, only the in-kind benefits would be subject to Section 409A. It would make little sense, however, to exempt one type of payment and not another. Therefore, if a severance plan is to be entirely exempt from Section 409A, it may only provide in-kind benefit payments for a “limited period of time.”

Compliance with Section 409A
In many cases, changing the plan terms just to squeeze into an exemption may do such violence to the design of a severance plan that it would be preferable to simply comply with Section 409A. Fortunately, bringing such plans into compliance with Section 409A is not too onerous. To comply with Section 409A, a severance plan should be amended:

• to eliminate any employer or employee discretion as to the time and form of severance payments; and
• if the employer is a publicly traded company, to delay distributions to key employees.

In addition, certain terms such as “termination of employment,” “key employee” and “change in control” should be defined as provided in the proposed regulations.

Time and Form of Payment and Deferral Elections
Section 409A requires, with limited exceptions, that a nonqualified deferred compensation plan participant make his or her irrevocable election to defer compensation in the year before the year in which the compensation is earned. A plan that does not allow deferral elections (as is generally the case with severance plans) must set the time and form of payment no later than the time that the participant obtains a legally binding right to the deferred compensation. Many severance plans allow employees to select among several payment options, such as a lump sum or installments, upon termination. (It is unlikely that an employer would want to ask employees to elect in advance how severance benefits will be paid, as this probably would send the wrong message to employees.) Therefore, severance plans subject to Section 409A generally should state the time and form of payment in the plan document, and not allow any employer or employee discretion as to the time and form of payment.

Severance Payments to Key Employees
Severance payments to a “specified employee” of a publicly traded company must be delayed for at least 6 months following termination. A “specified employee” is a key employee, as defined in Code section 416(i). Section 416(i) defines a key employee as an employee who, at any time during the plan year, is:

• an officer with annual compensation exceeding $140,000 (for 2006) (but if there are more than 50 officers, only the 50 officers with the highest compensation during the plan year are key employees);
• a 5-percent owner of the employer; or
• a 1-percent owner with annual compensation exceeding $150,000.

Special rules apply as to when key employee status begins and ends for purposes of Section 409A. The employer must select an “identification date” on which it will identify which employees are key employees. This date must be the same for all deferred compensation arrangements. The identification date may be changed, but any change cannot take effect for 12 months. Employees identified as key employees on the identification date are key employees for the twelvemonth period beginning on the first day of the fourth month following the identification date. For example, if the identification date is December 31, 2005 employees identified as key employees are key employees from April 1, 2006 through March 31, 2007.

The proposed regulations specify two techniques for delaying payments to key employees. The first is to delay any payment due within the six-month period until the end of the six-month period, so that all delayed benefits are paid, in one lump sum, in the seventh month following termination. The second technique is to delay each scheduled payment for 6 months, so that every payment is actually made 6 months after it was originally scheduled to occur. Since employees may not elect which technique is used unless the normal deferral election requirements are satisfied, the plan should specify which technique will be used. For example, a severance plan that provides employer-paid health coverage for 36 months following termination is subject to Section 409A because it does not satisfy the “limited period of time” requirement discussed above. This benefit must be delayed for 6 months with respect to key employees. The plan should specify that key employees must pay for their own health coverage during the six-month delay period. In the seventh month, the plan should either:

• reimburse key employees for the cost of coverage during the six-month period and pay for coverage for the next 30 months; or
• begin paying for coverage for the next 36 months.

Please contact us with your questions regarding the application of Section 409A to your severance benefit arrangements, as well as your other deferred compensation arrangements.