Severance Plans Under 409A

[401 Chaos]

I would also appreciate thoughts and clarification regarding coverage of severance plans or severance arrangements under 409A and Notice 2005-1. Unfortunately, the discussion in Q&A-19(d) does not add much clarification to me on what arrangements are clearly covered or what is required of covered arrangements.

For example, assume a company provides, either under an employment agreement or an executive severance plan, the continuation of an involuntarily terminated employee's salary for a period of 18 months. Assume the benefits are provided to key employees among other non-union employees involuntarily terminated in a Reduction in Force so the transition relief provided in Q&A-19(d) is not applicable.

For cash-flow reasons, the company is forced to make the severance payments on a monthly basis rather than provide the severed employee 18 months of severance benefits in a lump sum upon termination. In this case, the employee arguably has a legally binding right during a taxable year to "compensation" that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the agreement is payable to the employee in a later year. The severance amounts cannot be unilateraly reduced or eliminated by the employer. I assume this arrangement constitutes a "deferral of compensation" under Notice 2005-1, Q&A-4?

If so, what does 409A require? The payouts of these severance amounts are to be made on a fixed schedule--basically at the time monthly payroll is paid to active employees so there will be 18 checks paid out to the terminated employee over the next 18 months. There is no option for the terminated employee to accelerate distribution of these amounts. The terminated employee never made an "election" with respect to such severance benefits except to sign the initial employment agreement and/or any general release required. The amounts are not funded so the rabbi trust and offshore rules are not applicable.

Assuming the above-described arrangement is subject to 409A, does it really need to be amended to comply with the new rules? Are there issues that I am missing. If the employer is publicly traded, would the 6-month delay on distributions to Key Employees apply to "distributions" of severance benefits as well? Doesn't that in many cases defeat the whole purpose of offering the severance benefits. Also, what if the severance benefits are all to be paid out in the same taxable year--say over 6 months--would that avoid 409A? What if it is only a 6-month payout but it starts at the end of one year and finishes early the next year--different result?

Any thoughts would be appreciated.

[mbozek]

While I am not going to comment on the the specifics of Q/A-19(d) I do have some general observations:

1. 409A does not provide any general exception for severance plan payments subject to 409A because Congress did not want employers to evade the 409A restrictions by relabeling NQDC as severance.

2. Unless the IRS permits an exception, every plan that provides NQDC as defined by the IRS will be required to add the 409A language, the same as Q plans of a fortune 100 co which must contain TH requirements even though it will never become TH. (only govt plans are exempt from the TH requirements).

3. Periodic severance payments to non key ee will not be affected by 409A since the payments will be made for a fixed period and are unlikely to be paid to an off shore trust.

4. Periodic severance payments to key ee that are NQDC will be subject to a six month delay under 409A which will cause complications under the ADEA provisions for enforcing employee waivers which require that the employee receive some consideration not already promised by the employer in order for the waiver to be valid. The ee could be provided with other benefits to satisfy this requirement such as er paid COBRA or delay the waiver signing for 6 months. It is also possible that the sev. payments will be considered consideration under the ADEA even though they will be delayed for six months.

[Kirk Maldonado]

401 Chaos:

Why don't you bring this question to the attention of the IRS? That way we all might clarification of this issue in the future guidance under Section 409A.

[Guest Harry O]

Most garden variety severance plans where employees cannot defer receipt or accelerate payment of their benefits will not be impacted much by 409A. The exception is for severance payable to key employees. They will have to wait 6 months to start payment.

Since most severance plans require an employee to be terminated and sign a release in order to get payments, the vesting date would normally be the date that the employee signs the release (or maybe 7 days later when the revocation period ends). If all severance is paid out PER THE PLAN TERMS no later than 2.5 months following the severance "vesting" date, I believe the plan would not be considered deferred compensation and key employees could take the money and run without waiting 6 months.

I think mbozek is correct that the IRS is just nervous that it is not too hard to dress up a nonqualified deferred comp plan and call it "severance" and thus avoid 409A completely.

I would amend your severance plan to carve out key employees during 2005. This will immunize your rank and file employees from somehow getting whacked in some unforeseen way by 409A in 2005. You can then limit your handwringing to key employees receiving severance in 2005.

[Guest Harry O]

Amendment to prior post -

No deferred comp is paid no later than 2.5 months following the calendar year that the severance is first vested (or 2.5 months following the taxable year of the employer, if later).

[mbozek]

While I think that an ee could sign a valid waiver under the ADEA where payment was deferred to a future date, the realities of terminating key ees will not allow such a deferral. When senior execs leave the corp wants certain assurances such as confidentiality, non disparagement, non competition, etc. to be in effect immedately and the exec wants $$$$. Delaying the payment will be risky for both sides. It is more likely that key ee will receive a lump sum severance payment upon termination, e.g., exec signs agreement on Dec 23rd and receives payment on Dec 31 to comply with ADEA waiver rather than being foreced to wait 6 months. Alternatively the er could gross up the payment to the exec by 25% to pay the 20% penalty tax so that he could be made whole if he violates the 6 month restriction on receiving the payment (which is how corp. cope with the 280G restrictions).

[401 Chaos]

Thanks for everyone's comments. If I follow correctly, seems this is where we are:

1. Most ordinary severance benefits paid to non-Key Employees should not be affected much by 409A and plans that benefit only non-Key Employees basically get until the end of 2005 to figure out what, if anything, is required.

2. Severance benefits under plans or agreements paid to Key Employees (whether Key Employees of public or private companies) are potentially covered by 409A effective January 1, 2005. However, lump sum severane benefits paid to Key Employees should presumably escape the definition of a "deferral of compensation" under 2005-1 and thus escape regulation under 409A.

3. Periodic or installment payments of severance benefits to Key Employees, on the other hand, are likely clearly subject to 409A. In a private company context, this may be no big deal but for publicly traded companies this will generally require a 6 month delay in commencement of distribution of installment severance benefits. As Mbozek points out, the practical effect of this would appear to be that installment severance payments to Key Employees of publicly traded companies will largely become a thing of the past.

Harry O, I like your idea about trying to take advantage of the short-term deferral exception under Q&A-4 so that installment payments generally completed within 2 1/2 months of the end of the year the benefits vest are removed from the definition of a deferral of compensation. What bothers me about that though is it would appear to allow a Key Employee terminated in January to basically receive severance benefits in installments over 13 1/2 months while a Key Employee terminated in December could only receive 2 1/2 months of installments (assuming both employer and employee are on calendar year). While that may be useful in negotiating individual severance benefits with Key Employees at the time of termination, it is difficult to take advantage of that in drafting plans / agreements in advance or trying to fix previously negotiated agreements that allow for prolonged installment distributions.

I also have a question with respect to the 6-month delay on distributions to Key Employees of publicy traded companies. Since that requirement only appears to apply to distributions made upon a separation from service under 409A(a)(2)(A)(i), would severance benefits paid to a Key Employee upon termination (separation from service) following a Change in Control Event be excepted from the 6 month delay requirement so that they could be paid in installments or would such a double trigger still be subject to rules applicable to distributions upon a separation from service?

Kirk, I would like to pose these questions to the IRS and may make a formal submission along those lines down the road. Unfortunately, my client is facing some immediate termination issues and needs guidance now. As expected, I believe the good folks here have provided useful confirmation and insight in the interim. I know the JCEB website received some severance questions for the last conference call that the IRS didn't have a chance to cover. Maybe they will cover some of these on January 6th but I'm not holding my breath. Thanks again.

[Kirk Maldonado]

401 Chaos:

I think that your original posting could be submitted to the IRS, with some minor edits. They will accept informal comments.

Just in case you don't know, they have an e-mail address that you can use to submit comments on this project, so you don't have to go through the hassle of putting it into letter format, mailing it, etc.

[TCWalker]

And, I think you need to take this a step further an look at a situation where Exec negotiates an on-boarding employment contract that entitles her/him to a defined severance pay at termination. Later, Exec. renegotiates E-K which has the effect of accelerating, improving the severance deal. It better comply with 409A, or someone's, possibly, on the hook for an additional 20%.

I think some 409A indemnification language may become the standard in E-Ks.

[Guest msalsbury]

This was a very interesting discussion (and very relevant to an issue we are dealing with).

Has anyone thought through to what extent Section 409A may apply to the provision of post-termination medical benefits where the Executive is a "key employee"? The situation is that a "key employee" of a public company has negotiated to have the Company pay for the continuation of health insurance, post-termination, for the Executive's and Executive's spouse's lifetime.

We are concerned that if the provision of medical benefits is treated as deferred compensation subject to Section 409A, there would appear to be some issues regarding compliance with Section 409A. First, how does one comply with the six-month rule? For example, would you be required to have the Executive reimburse the Company for the cost of coverage for the first six months (termination of health coverage is obviously not an option)? Also, it is not clear that the "compensation" would be paid pursuant to a fixed payment schedule.

While I expected to see an exclusion from Section 409A for these types of benefits, I can't seem to find anything explicit that provides any comfort. For example, this type of benefit does not appear to be among the types of welfare plans that are listed in Notice 2005-1, Q&A 3©.

Does anyone here have any thoughts?