Articles

Employment Law Alert – IRS 409A’s Impact on Severance or Deferred Comp

January 30, 2009

Any employer who is including a severance provision in an offer letter to a prospective new hire, offering post-termination payments to a departing employee, or implementing any deferred compensation arrangement or severance plan or policy needs to carefully consider the impact of Section 409A of the Internal Revenue Code. Congress enacted Section 409A in 2004 as part of the American Jobs Creation Act.

Since then, proposed and now final treasury regulations regarding 409A, along with additional notices and other related guidance issued, form a complex set of legal rules that impose serious financial consequences for a misstep.

The consequences of failing to meet the requirements of Section 409A are costly.  Income deferred under the arrangement must be included in the employee’s income currently, eliminating the potential tax benefits of deferring the compensation in the first place.  Section 409A also imposes an additional federal penalty of 20% of the tax due on the amount of deferred compensation upon a determination that the arrangement is not in compliance with Section 409A.  Other penalties and interest could also be imposed.  Further, state income tax authorities may impose penalties for failing to comply with Section 409A.  For example, California imposes its own 20% penalty for failing to comply. The employer may risk liability for failure to properly report income paid to the employee, or for improper deductions.

Section 409A applies to a broad range of deferred compensation arrangements, such as severance plans, even if those compensation arrangements were created prior to the statute’s effective date of January 1, 2005.  Before making payments pursuant to such older compensation arrangements, employers should consider the impact of Section 409A.  More importantly, employers must ensure, however, that compensation arrangements drafted in the future comply with Section 409A. Section 409A generally applies to all nonqualified deferred compensation plans.

The term “nonqualified deferred compensation plan” includes any plan that provides for the deferral of compensation.  A plan provides for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider (employee) has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan or arrangement, is or may be payable to (or on behalf of) the employee in a later taxable year.  Such compensation is treated as deferred compensation for purposes of Section 409A.

Because the definition of a “nonqualified deferred compensation agreement” is written broadly, the following arrangements are potentially subject to Section 409A:

  • Employment agreements, including offer letters
  • Severance and/or change-in-control arrangements
  • Stock, stock option, and stock appreciation rights (SAR) plans or arrangements
  • Bonus or commission plans
  • Reimbursement arrangements
  • Split-dollar life insurance policies
  • Tax gross-up payments
  • Deferred Compensation Plans or Agreements

Where an arrangement is subject to Section 409A, it must satisfy three requirements:

The first requires that the compensation deferred under the arrangement is not distributed earlier than six different possible events.  The six events are: a participant’s separation from service, a participant’s disability, a participant’s death, a specified time or pursuant to a fixed schedule, a change in ownership or control of the service recipient, or the occurrence of an unforeseeable emergency.

Secondly, although several exceptions exist under the Treasury Regulations relating to Section 409A, generally a plan may not allow for the acceleration of the time or schedule in which benefits are paid under the plan.

Finally, the plan must comply with various restrictions on elections provided under the plan, such as for the initial election to defer compensation under the plan, as well as for later elections to change the time or form of distribution under the plan.

Amongst the several exceptions to the Section 409A requirements, employers have attempted to
utilize three in particular in drafting severance provisions:

  • the “short term” deferral exception
  • the “2x2” exception
  • the “reimbursement exception”
  •  

Careful analysis and drafting of the severance provision is essential to ensure the exception will apply. 

For example, the “short term” deferral exception may permit severance compensation to be paid by March 15th of the year after the year in which the termination occurs. However, this is not a simple rule that can be applied in a vacuum to every situation, and a publicly traded company may run afoul of the “specified employee” delay requirement which mandates a delay of six months following separation for severance payments to the top officers whose annual compensation is greater than a particular dollar threshold.

For further information, please contact the following Berliner Cohen attorneys at 408.286.5800:
    Jerold A. Reiton, jerold.reiton@berliner.com
    Aaron Valenti, aaron.valenti@berliner.com
    Roberta Hayashi, roberta.hayashi@berliner.com

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Berliner Cohen is one of the largest law firms in San Jose serving the business and regulatory needs of private business and public agencies.  For almost 40 years, the Firm has developed its full-service, special expertise required by a diverse client base consisting of some of Silicon Valley’s largest corporations, new ventures, leading real estate developers, cutting-edge software manufacturers, healthcare providers, mortgage banking companies, municipalities and public agencies.  Berliner Cohen also meets the growing demands of the San Joaquin Valley with its expanding office in Merced.

© 2009 Berliner Cohen.  This Berliner Cohen Employment Law Alert is only a general overview of how Section 409A may apply to employee severance provisions and the consequences of failing to consider its requirements.  When drafting arrangements that may involve issues of compliance with Section 409A, employers should seek professional assistance with respect to their specific concerns.  This Alert is not intended to and does not constitute legal advice or a solicitation for the formation of an attorney-client relationship and no attorney-client relationship is created through your receipt of the materials.