Severance Pay and Security Agreement

[Guest MI-Attorney]

We have a client who is a 1/3 owner of a company. His employment will be terminated when he turns 55 and he will receive a severance package which will not be exempt from 409A as it will be paid over 5 years and exceed the short-term payment amount. In addition, his stock is being purchased and he will be provided with a promissory note which will be secured by the assets in the company. The question is can the severance payments also be secured under the security agreement? I do not see anything about this, however, I am worried that this will somehow make the plan noncompliant with 409A. Any comments are appreciated.

[jpod]

You should be ok as long as there is nothing in the arrangement that would trigger an acceleration of the severance payments. If so, more facts and further analysis are necessary.

[Everett Moreland]

I believe that securing the severance pay will result in the severance agreement being a transfer of property subject to taxation under IRC Section 83. See the following from 1.83-3(e):

"For purposes of section 83 and the regulations thereunder, the term 'property' includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future."

[jpod]

Everett: I haven't studied the issue (at least not that I can remember), but I don't think that a promise to pay money as compensation in the future would ever be considered a transfer of property under Section 83, even if that promise is secured by a lien or other interest in property.

[401 Chaos]

I haven't researched this under 409A and it's been a long time since I've looked at it otherwise but I think a key aspect may be just how much security the note provides the individual with respect to other creditors and whether it simply provides rights to the company's general assets or a particular asset or piece of property.

If the note merely provides further documentation that the Company has an obligation to pay but doesn't put the individuals ahead of or in a better position than general creditors of the company, seems there may be an argument that this is ok. My recollection is that there are some private letter rulings or other guidance where a parent of one company provided a promissory note to cover deferred compensation plan obligations of a subsidiary or affiliate and that the Service found those not to be a problem. Obviously, I suppose that could vary a lot depending on facts and circumstances and the particular terms of the note.

[Guest MI-Attorney]

I haven't researched this under 409A and it's been a long time since I've looked at it otherwise but I think a key aspect may be just how much security the note provides the individual with respect to other creditors and whether it simply provides rights to the company's general assets or a particular asset or piece of property.

If the note merely provides further documentation that the Company has an obligation to pay but doesn't put the individuals ahead of or in a better position than general creditors of the company, seems there may be an argument that this is ok. My recollection is that there are some private letter rulings or other guidance where a parent of one company provided a promissory note to cover deferred compensation plan obligations of a subsidiary or affiliate and that the Service found those not to be a problem. Obviously, I suppose that could vary a lot depending on facts and circumstances and the particular terms of the note.

Thanks for your comments. Upon review of what everyone said, I am thinking a security agreement would (at least potentially) violate 409a. First, the nature of the security agreement would accelerate the payments upon default. If the company did not pay and the employee executed on the secured interest, the employee is able to take the collateral and sell it and apply against the debt. Also, regarding 401 Chaos' comment, a security agreement would put the employee ahead of all unsecured creditors and also ahead of any secured creditors who file subsequent to the employee's filing.

[Steelerfan]

I don't think the security agreement violates 409A, I think it causes taxation. Section 83 property includes a beneficial interest in assets set aside from creditors of the company. Read the legislative history to 409A. The economic benefit doctrine and constructive receipt still applies, so you are not violating 409A, but rather causing immediate taxation, so 409A becomes irrelevant since there is no deferral of income taxation.