Final Section 409A Regulations and Severance Pay

Introduction

The IRS recently published final regulations under Section 409A of the Internal Revenue Code (the "Final Regulations"). As interpreted by the Final Regulations, Section 409A applies to many types of plans and agreements, including in particular severance plans and employment or change in control agreements that provide severance and other posttermination payments. In general, the Final Regulations retain many of the provisions relating to severance plans that were initially set forth in the proposed regulations with a number of helpful modifications.

Under the Final Regulations, certain types of severance arrangements are specifically exempt from Section 409A. First, Section 409A requirements do not apply to an arrangement that provides for severance pay only (i) in connection with a "window program" that offers incentives to certain groups of employees to terminate employment voluntarily during a limited period of time not to exceed 12 months, or (ii) upon involuntary termination of employment – in both cases subject to payment of limited amounts over a limited period of time. Second, certain severance pay that is payable in a lump sum can be structured to meet the short-term deferral exception from Section 409A coverage. Third, certain arrangements providing for expense reimbursements or in-kind benefits for a limited period of time following a separation from service are exempt from Section 409A coverage. Fourth, certain bona fide collectively bargained severance plans are not subject to Section 409A.

It should be noted that the Final Regulations allow these exceptions from Section 409A coverage to be used in combination. For example, if an employee has a right to the maximum severance available under the exception applicable to involuntary terminations and that same employee is also entitled to reimbursement of outplacement expenses for one year, such employee may exclude both amounts from Section 409A coverage by taking advantage of the two separate exceptions.

As stated above, the Final Regulations generally retain the exception from Section 409A coverage contained in the proposed regulations for rights to severance payments resulting from an involuntary separation from service or participation in a window program, subject to the following requirements:

• The aggregate amount of severance pay is not subject to Section 409A to the extent it does not exceed two times the lesser of (i) the employee’s annualized compensation for the preceding calendar year or (ii) the maximum amount that may be taken into account as compensation under the qualified plan compensation limit in effect for the calendar year in which the termination occurs (currently $225,000).
• All of the severance pay must be paid by no later than December 31 of the second calendar year following the calendar year in which the termination occurs.

If severance pay meets the above requirements, then such pay will not be subject to Section 409A, including the six-month delay imposed on payment of deferred compensation to specified employees (i.e., certain key employees of public companies) on account of separation from service. Importantly, the Final Regulations provide that this exception may also be applied to situations where the aggregate amount of severance pay exceeds the dollar or time limit described above. However, in such instances, the severance payments must be divided into Section 409A and non-Section 409A portions, with only the non-Section 409A portion (i.e., the excess over the dollar or time limit) being considered deferred compensation subject to the requirements of Section 409A, including the six-month delay, if applicable. The non-Section 409A portion can be paid without application of the six-month delay.

The proposed regulations did not treat a termination for good reason as an involuntary termination event. This was problematic because the other exceptions to Section 409A are not applicable to severance paid in connection with a voluntary termination. However, the Final Regulations deem a termination for good reason to be an involuntary termination in certain situations. Whether a termination of employment is considered to be for good reason is determined based on the specific facts and circumstances of such termination. In addition, the Final Regulations provide a safe harbor definition of good reason. The safe harbor definition of good reason requires that any one or more of the following conditions arise without the consent of the employee:

• a material diminution of base salary;
• a material diminution in the employee’s authority, duties or responsibilities;
• a material diminution in the authority, duties or responsibilities of the supervisor to whom the employee is required to report, including a requirement that an employee report to a corporate officer or employee instead of directly to the board of directors;

• a material diminution in the budget over which the employee retains authority;
• a material change in geographic location at which the employee must perform the services; or
• any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.

In addition, the safe harbor requires (i) that any amounts payable upon a good reason termination be paid only if the employee actually terminates employment within a limited period of time not to exceed two years following the initial existence of the good reason condition and (ii) that the amount, time and form (lump-sum or installments) of payment upon a termination of employment for good reason be the same as the amount, time and form of payment payable upon an involuntary termination without cause. The employee must also provide notice to the employer of the good reason condition within 90 days of the initial existence of the condition and the employer must be given at least 30 days to remedy such situation.

Since the Final Regulations recognize termination for good reason in certain circumstances as an involuntary termination, employment agreements that provide lump sum severance pay upon termination without cause or termination for good reason may now qualify for the short-term deferral exception to Section 409A. If this exception applies, there is no cap on the amount of severance pay that can be paid in a lump sum and the six-month delay on payments to specified employees does not apply at all. Of course, the definition of good reason must meet the requirement of the Final Regulations, and the severance pay must be made during the short-term deferral period.

The Final Regulations expand the type of reimbursements and in-kind benefits that are excluded from Section 409A, including the following:

• Reimbursement of expenses incurred by a terminated individual to the extent the reimbursements are excludable from the individual’s taxable income, are for reasonable outplacement or moving expenses, or relate to deductible business expenses – but, in each case, only if such expenses or in-kind benefits are incurred no later than December 31 of the second calendar year following the calendar year in which the termination occurs. While the expenses must be incurred by the end of the second year, the Final Regulations allow an extra year for the Company to actually make the reimbursements.
• Reimbursement of medical benefits or premiums that are taxable to the terminated individual, such as those provided by a self-insured health plan that does not meet the IRS non-discrimination rules, but only to the extent such reimbursements are made within the COBRA period (generally 18 months following termination of employment or eligibility for another employer’s group health plan coverage, if earlier). Any reimbursement beyond the COBRA period must comply with the Section 409A rules.
• Reimbursements or any other payments provided in connection with severance are not subject to Section 409A in any event if they do not exceed the dollar limit on elective contributions to a 401(k) plan (currently $15,500).

In addition, the Final Regulations clarify that a loss incurred by the employee due to the sale of a primary residence may be considered a reasonable moving expense eligible for reimbursement treatment under Section 409A, provided that the reimbursement does not exceed the actual amount of the loss incurred by the employee.

The exception from Section 409A coverage with respect to collectively bargained severance arrangements requires that certain conditions be satisfied including that the severance arrangement be established and maintained pursuant to an agreement that the Secretary of Labor determines to be a collective bargaining agreement and that the severance arrangement provided by such agreement is the result of arm’s-length negotiations in good faith between employee representatives and any employer parties.

The Final Regulations will become effective on January 1, 2008. All nonqualified deferred compensation arrangements subject to Section 409A must be amended by yearend to meet the written documentation requirements of Section 409A. One such requirement is the six-month delay for any payment of deferred compensation to specified employees on account of separation from service. Therefore, all employment agreements, change in control agreements and severance pay plans or arrangements should be reviewed before year-end to determine whether severance payable under such arrangements is subject to, or exempt from, the application of Section 409A. In many instances, amendments may be necessary to ensure availability of one or more of the exceptions from Section 409A coverage. For instance, the definition of good reason may need to be tightened if the relief discussed above is desired. Severance pay arrangements that are subject to Section 409A should be amended before December 31, 2007 to comply with the written documentation requirement of Section 409A, including the addition of the six-month delay rule for specified employees.

Section 409A requires that all plans or arrangements subject to its requirements be set forth in a written plan document. Therefore, "informal" severance policies should be reviewed to determine whether a plan document is required.

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