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Locust

409A separation pay

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Here is an issue on the interplay of various exemptions from 409A for separation pay.

I've read that in order to meet the 2 X pay/over 2 year exception all payments made on separation are aggregated, so that if an executive received a lump sum severance payment of 2 X pay immediately following separation and additional installment payments over a year, that the aggregated amount (both the lump sum and the installments) would be subject to 409A, because 1. it doesn't meet the short term deferral rule because payments extend beyond the short term deferral period, and 2. it doesn't meet the 2Xpay/2 year exception because it exceeds 2 X pay.

If that is the case, and if you had a specified employee, the entire amount would be in violation because payments in the first 6 months violate the 6 month rule. Since all the payments are aggregated, all of the scheduled payments would be taxed immediately and subject to penalty.

Do you think that is a correct reading of the separation pay/short term deferral exceptions from 409A?

It makes sense to me, but I've seen various comments that seem to say that all separation payments due within the short term deferral period would be exempt from 409A. If this is true, it would be helpful to me to understand the basis for it.

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I've read that in order to meet the 2 X pay/over 2 year exception all payments made on separation are aggregated. Do you think that is a correct reading of the separation pay/short term deferral exceptions from 409A?

Can you find a basis for aggregation of severance payments in the regs? I thought the issue was created because the regs allow for bifurcated payments and I am not aware of any aggregation requirement for severance.

I've seen various comments that seem to say that all separation payments due within the short term deferral period would be exempt from 409A. If this is true, it would be helpful to me to understand the basis for it.

The basis for it is that severance paid upon involuntary termination consitutes a substantial risk of forfeiture thus allowing the short term deferral rule to apply.

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Guest mjb

See PLR 199923045 for the answer.

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steelerfan -

I think the basis for the aggregation is the definition at 1.409A-1©(2)(D) "All deferrals of comepnsation with respect to that service provider under all separation pay plans [with certain exceptions]. . are treated as deferred under a single plan."

I think you have to have this rule, otherwise the 6 month restriction on payments on account of separation to a specified employee (publicly traded cos.) would be too easy to avoid in the context of separation pay plans - the plan would pay the first 6 months of payments by the end of the short term deferral period, then pay the rest after the end of the 6 month period.

Also, the 2Xpay/2 year exception would be fairly meaningless - just stick all of the separation pay in excess of 2x pay in the short term deferral period.

LS

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steelerfan -

Also, the 2Xpay/2 year exception would be fairly meaningless - just stick all of the separation pay in excess of 2x pay in the short term deferral period.

LS

That is the point i've been trying to make. Hogans confirmed you can avoid the 2Xpay/2 year exception and the 6 month rule with the ST deferral rule. There is some reason to be skeptical about avoidance of the 2X/2 year rule I think though when bifurcated payments are made. In that case it has to be clear that each payment is a separate paymebt

As far as the original basis for the short term deferral rule, that is explained in the legislative history to 409A. Congress stated "It is intended that the provision does not apply to annual bonuses or other annual compensation amounts paid within 2 1/2 months after the close of the taxable year in which the relevant services required for payment have been performed." I think this has its roots in section 404--accrual basis taxpayer (corporations) deductions. The FICA regulations have the same rule.

What I meant about its basis in applying to separation pay is that involuntary terminations are a substantial risk of forfeiture (as per the regulations). So up until termination, the payment is under an SRF meaning that if the employee were to leave employment voluntarily, he would have no right to payment. Thus if an employee is involuntarily terminated in 2007, the employer can pay the total amount of severance by March 15, 2008 and that amount may exceed 450,000.

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steelerfan -

I think the basis for the aggregation is the definition at 1.409A-1©(2)(D) "All deferrals of comepnsation with respect to that service provider under all separation pay plans [with certain exceptions]. . are treated as deferred under a single plan."

I don't see that provision as requiring all payments to be aggregated.

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What is the basis for the S-T deferral rule in the first place (why 2 1/2 months vs. 3 or 4 if it pushes to the next tax year anyway)?

The preamble to the regs discusses this. Commentators tried to make that argument, but Treasury is adhering to Congressional intent as set forth in the legislative history. However, with the proper language in your plan you can have until the end of the calendar year anyway, so there no need to worry too much about the magical 2.5 months.

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Guest Harry O

The 2.5 month builds off the longstanding rule under Section 404 regarding when compensation is deferred for the deduction timing rules. The regulations provide that is a payment is made within the 2.5 month period it is not deferred compensation and, for accrual basis taxpayers, can generally be deducted in the year it accrues (which may be earlier than the year the employee includes the compensation in income). If the compensation is paid after the 2.5 month period, it is deferred compensation that is only deductible when paid to the employee. Since there was already a rough definition of deferred compensation under Section 404, it only made sense to import into Section 409A. However, Section 409A provides much greater detail than the 404 regs do on how this 2.5 month rule works and employers should keep the 409A rules in mind when they try and figure out when something is deductible.

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Guest jhall

Assuming one is comfortable relying on Hogans' statements and wishes to take advantage of the stacking concept, has anyone seen a model provision or developed what they think is particularly good language to do this.

We are looking at a situation where public company would like to retain the opportunity to pay out severance in either a lump sum or in installments, in the company's discretion with the decision to be made at the time of separation. Historically, the company has elected installments where there is a concern about needing to police noncompetes and/or desires not to have a large cashflow hit.

All severance amounts--even if company elects to pay in installments--would be paid out within 2 years of separation from service so timing is likely not an issue for 409A purposes. However, severance provisions do not place any cap on maximum severance amounts to be paid other than they basically go up to a max of 2 times pay. That 2 times pay amount, in some cases, will exceed the max. dollar amount permitted under the separation pay exception. Without capping the severance to fit within the separation pay exception, seems that exception cannot be relied on here. As a result, the amounts would not be exempt from 409A. That, in turn, would require the 6 month rule to apply to specified individuals and would also mean that the employer's discretion over whether to pay in a lump sum or in installments would violate 409A's need to set fixed payment terms.

Company very much wants to retain ability to decide between lump sum and installments and also avoid 6 month delay in distribution for specified employees. In vast majority of cases where the maximum severance amounts exceed the max allowed under the separation pay exception, the excess amounts are not likely to be particularly large. As such, the company would be willing to pay the entire excess amount out within the short term deferral period--actually fine paying it out in a lump sum immediately following separation from service if that exempts them from 409A and its 6 month delay requirement.

I am not sure I understand the discussions I've seen about the need to specify that each installment payment be characterized as an individual payment rather than a single severance payment when trying to stack the exceptions and take advantage of both STD and separation pay exceptions. Part of my confusion is wondering whether that sort of designation of separate payments helps when you don't know how much total severance is, how much in excess of the maximum separation pay exception is, or how long the short term deferral window will be when drafting the employment agreement because you never know when separation will occur.

My instinct is to try and draft a provision so as to require the total severance amount to be separated / bifurcated into two separate amounts or buckets, each with its own terms hopefully permitting it to be exempt from 409A. That appoach seems to work best where the company doesn't know what the severance amount will be or what the cap will be, or whether or not it will pay all amounts in installments or lump sum.

The provision I envision would first provide for an individual's total severance amount (t) under the agreement to be calculated. The total severance amount (t) would then be divided into two separate severance amounts for payment to the former employee. The first severance amount (x) would be calculated by taking the maximum severance amount permitted under the 409A separation pay exception at the time of separation and would then be payable, in either a lump sum or installments in the company's discretion, to the individual no later than 2 years following the individual's separation from service. The second severance amount (y) would be equal to the difference of total severance (t) minus the first severance payment (x) and would be paid out in a lump sum within 30 days of separation from service.

Anybody see an easier or better way to structure this or an easyier way to draft such a provision.

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jhall - I still think that you may have to aggregate all severance payments, including those made within the ST deferral period, in applying the 2 x limit under the 2 year rule. Under your scenario, this would mean that the amounts in excess of the 2 x limit would be subject to 409A and the discretion to accelerate would result in 409A taxes on the amount in excess of 2 x limit that are not required to be paid within the ST deferral period. So if you had $1 million due on severance payable within 30 days, and $450,000 payable at the company's discretion over a 2 year period, you'd have $1 million in excess of the 2 times limit, but only $450,000 would be subject to the 409A tax.

See Reg. ss 1.409A-1©(2)(D) "All deferrals of compensation with respect to that service provider under all separation pay plans [with certain exceptions]. . are treated as deferred under a single plan."

So far as what Hogan says, I wasn't there, and I haven't seen any reference to a section of the regulations that would allow a bifurcation of separation pay for purposes of the 2 year rule.

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Locust--I don't mean to suggest that your concerns aren't legitimate, I just think the IRS and Treasury have given us sufficient tools in these cases to "get around" otherwise problematic limitations.

First, that "all deferrals of compensation . . . are treated as deferred under a single plan" does not mean that you can't bifurcate payments under that single plan. The concept of bifurcation is pretty well settled in various places of the regs, and is consistent with the concept of aggregating to a single plan. Payments, other than annuties, can be treated separately for various purposes, such as applying a different distribution event or, as here, applying the STD exception within the confines of a single plan or "aggregated plan."

Second, when you have a STD, you do not have a "deferral of compensation", so you would not have to aggregate that payment, as you say, into the separation pay plan because an amount that is not a deferral of compensation is not by definition separation pay. Thus, if you bifurcate your payment properly you can make it independent of the separation pay plan by making it a STD. Without that "independence", I'd say you're right it can't be done. But the regulations and its authors provide support for it.

jhall--Unless I'm missing something, the general language necessary to accomplish your goal should not be too difficult. It's the operation and administration that scares me.

For example, you could say something like "to the extent the total severance benefit exceeds the lesser of (a) 2x prior year's pay or (b) 450,000, such excess amount shall be treated as a separate payment and shall be paid in full in the form of a lump sum or installments no later than March 15 of the year following the year of involuntary separation from employment. " The remaining 450,000 would be exempt from 409A, so the employer could retain it's discretion to pay that amount in any manner upon termination. Do you see reason why that wouldn't work?

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