Section 409A Compliance:
Employment Agreements and Separation Pay Arrangements
(December 12, 2005)

Overview

Separation Pay Arrangements

Employment Agreements

Traps for the Unwary

Future Alerts

On September 29, 2005, the Treasury Department and IRS issued long-awaited proposed regulations regarding deferred compensation agreements under Section 409A of the Internal Revenue Code.  This alert, the fourth in a series regarding Section 409A compliance and the proposed 409A regulations, discusses the compliance issues relating to employment agreements and separation pay arrangements.

Overview

Section 409A will be an issue for most employment agreements and separation pay arrangements because they typically include features that are treated as deferred compensation under the new rules.  In other words, such agreements and arrangements usually include one or more promises creating a service provider’s legally binding right during a taxable year to compensation that has not been actually or constructively received and included in income, and that is payable to or on behalf of the service provider in a later year.  For example, an employment agreement may provide deferred compensation in the form of future severance benefits, supplemental retirement payments or tax gross-ups.

If an agreement or arrangement includes deferred compensation features and those features are not exempted from Section 409A, they will have to comply in form and operation with the new rules.  If a feature does not comply, the employee or contractor entitled to the benefit will suffer the direct adverse tax consequences.

[Top]

Separation Pay Arrangements

Under the proposed regulations, an arrangement that provides for deferred compensation will not escape regulation under Section 409A merely because it is bona fide severance or separation pay.  Thus, any written or unwritten policy, plan or arrangement providing severance benefits is potentially subject to Section 409A.  This will be true even if the benefits are conditioned upon the execution of a release of claims, or compliance with non-competition or non-disclosure covenants or other similar requirements.

Unless it is exempt from Section 409A as described below, a separation pay arrangement must be designed and operated in compliance with the Section 409A payment timing restrictions.  This means the arrangement must specify when and in what form payments will be made to a terminated participant and, if applicable, must comply with the “key employee” rule described later in this article.  Payments generally cannot be accelerated, and payments can be delayed only by complying with Section 409A’s redeferral  rules.  Separation pay arrangements will have to be amended to comply with these rules by December 31, 2006, and must be operated in good faith compliance beginning in 2005.  Employers will also want to review their separation pay arrangements as soon as possible to determine whether it makes sense to terminate or modify the arrangements in 2005 under applicable transition guidance.

Companies that do not have a written plan or policy should consider adopting one even if they only provide separation pay on rare occasions or on an ad hoc basis.  A written plan or policy can even provide that separation or severance benefits will be completely discretionary, as determined by the company.

A separation pay arrangement can be designed so that it will be exempt from Section 409A.  The proposed regulations provide specific exemptions for the following types of separation pay arrangements:

• Short-Term Deferrals.  A short-term deferral of payment is not treated as deferred compensation and is therefore exempt from Section 409A.  A separation pay arrangement will be exempt from Section 409A if all payments will qualify as short-term deferrals under the regulations.  An arrangement that provides benefits only for involuntary terminations will be exempt from Section 409A under the short-term deferral rule so long as all payments are made within 2 ½ months after the end of the year in which the involuntary termination occurs.  However, if the arrangement also provides for severance benefits following an employee’s voluntary termination under certain circumstances, it might not qualify for the short-term deferral exception unless the arrangement is carefully designed as a completely discretionary program with no pre-determined benefit formula.

• Involuntary Terminations or Window Programs.  The proposed regulations provide that a separation pay arrangement will be exempt from Section 409A if (i) the arrangement provides for payment only upon involuntary termination of employment or upon termination pursuant to a window program, (ii) payment does not exceed two times the lesser of the service provider’s actual compensation for the preceding calendar year or the annual compensation limit for qualified retirement plans ($220,000 for 2006), and (iii) all payments are made no later than December 31 of the second calendar year following the year in which termination of employment occurs.

• Reimbursements.  The proposed regulations exempt certain expense reimbursements from Section 409A.  The expenses must be incurred and the reimbursements must be paid by the end of the second calendar year following the year in which termination of employment occurs.  Allowable expenses include deductible business expenses and reasonable outplacement and moving expenses related to the termination.

• De Minimis Payments.  Under the proposed regulations, de minimis benefits that are otherwise not exempt from Section 409A will be exempt if the total payments or benefits do not exceed $5,000 in the aggregate.

• Union Plans.  A collectively bargained separation pay arrangement that provides for payment upon involuntary termination or upon termination pursuant to a window program is not subject to Section 409A.

[Top]

Employment Agreements

As noted above, most employment agreements will have features that raise issues under Section 409A.  Employers should review their employment agreements as soon as possible to identify features that are treated as deferred compensation under Section 409A, and to determine whether it makes sense to terminate or modify any of those features in 2005 under applicable transition guidance.

As with separation pay arrangements, deferred compensation features in an employment agreement must be designed and operated in compliance with the Section 409A payment timing restrictions, absent a Section 409A exemption.  If the employment agreement provides for severance benefits following termination of employment, it will be subject to the general rules applicable to separation pay arrangements described above.

Change in Control Payments.  Many executive employment agreements include payment or acceleration triggers in the event of a “change in control” affecting the employer.  A change in control is a permitted acceleration event under Section 409A, but the change in control must be a recognized change in control as defined in the regulations.  The definition in the regulations is narrower than the definition found in many employment agreements, and those agreements will have to be amended before December 31, 2006 to comply with Section 409A.

Payments Following Voluntary Termination.  Under the proposed regulations, a promise to provide severance benefits following an employee’s voluntary termination will be subject to Section 409A unless it is structured to qualify as a short-term deferral.  In order to qualify as a short-term deferral, the agreement must provide that all payments will be made within 2 ½ months after the end of the year in which the payments are no longer subject to a “substantial risk of forfeiture” within the meaning of Section 409A.  Otherwise, the voluntary termination benefit provisions must be designed and operated in compliance with Section 409A, and any necessary amendments must be adopted by December 31, 2006.

Substantial Risk of Forfeiture.  Whether a termination payment is subject to a substantial risk of forfeiture depends on the terms of the employment agreement and the surrounding facts and circumstances.  A payment is subject to a substantial risk of forfeiture if it is conditioned on the performance of substantial future services or the occurrence of a condition related to the purpose of the payment, and the possibility of forfeiture is substantial.  For example, in the case of a payment following an executive’s voluntary termination for “good reason,” the payment would not be subject to a substantial risk of forfeiture once the circumstances establishing “good reason” are present.

Non-Compete Agreements.  The proposed regulations specifically state that an agreement to refrain from performing services (as in an agreement not to compete) will not be sufficient to create a substantial risk of forfeiture.  For example, if an employment agreement provides for the payment of consulting fees after termination of employment conditioned only on compliance with a non-compete, and the consulting fees will be paid whether or not the individual provides any consulting services, those fees will be treated as fully vested and not subject to a substantial risk of forfeiture for purposes of Section 409A.

[Top]

Traps for the Unwary

Unfortunately, employment agreements and separation pay arrangements are likely to become Section 409A compliance traps for companies and their advisors, in part because such arrangements have not traditionally been thought of as deferred compensation.  To avoid subjecting their employees to severe adverse tax consequences, companies will need to be sure their employment agreements and separation pay arrangements are reviewed for Section 409A issues, and that appropriate steps are taken to bring documents and administrative practices into compliance.

Future Alerts

If you have any questions regarding this alert or other Employee Benefits Law related issues, please contact one of our Employee Benefits attorneys.

[Top]