Section 409A was added to the Internal Revenue Code by Congress in 2004 to tighten the rules governing deferred compensation plans.  Although Section 409A does not apply to most severance plans or agreements, it will apply in some cases.  If Section 409A applies and the agreement fails to comply with the fairly onerous requirements contained in Section 409A, it can result in accelerated income taxes plus interest and a 20% penalty tax payable by the employee.  This article discusses some common ways to structure a severance agreement to avoid Section 409A.

Exception for Qualified Separation Pay Plans

Section 409A does not apply to a qualified “separation pay plan,” which is defined in IRS regulations as a plan or agreement that satisfies three requirements.  First, the plan must provide for payment due to an involuntary termination of employment by the employer, termination by the employee for good reason, or termination pursuant to a window program.  The terms “good reason” and “window plan” are defined in IRS regulations.  Second, the amount of separation pay cannot exceed two times the lesser of: (a) the employee’s annualized compensation in the prior year, and (b) the current IRS limit on includible compensation for qualified retirement plans ($330,000 for 2023).  Finally, the separation pay must be paid by the last day of the second calendar year following the year of termination.  

A collectively bargained plan that provides for payment upon an involuntary termination, a  termination for good reason, or pursuant to a window program will qualify for this exception without having to satisfy the conditions relating the amount and time of payment.      

Exception for Short-Term Deferrals

If a severance agreement cannot qualify for the exception for qualified separation pay plans, it may be exempt under the short-term deferral rule, also known as the vest and pay rule.  To satisfy this exception, all of the payments must be completed within two and a half months after the end of the calendar year in which the employee’s right to the payment becomes vested, i.e., the employee acquires a binding right to receive the payment.  This generally means that as long as an employee receives all of their severance payments by March 15 of the year following the year in which they terminate employment, the payment will not be subject to Section 409A.

A severance payment can be contingent on the employee signing a release of claims before a designated payment date.  

Exception for Other Benefit Payments

An employer’s reimbursement pursuant to a separation agreement of an employee’s business expenses, outplacement costs, moving expenses, and medical expenses during the COBRA continuation period are also not subject to Section 409A.

Conclusion

In summary, it is not overly difficult to structure a severance pay agreement to avoid Section 409A.  A fairly easy way is to have the benefits paid in a lump sum before March 15 of the year following the year of termination.  This won’t work, however, for an employer who wants to spread out the payments for cash flow reasons or to ensure the employee complies with their restrictive covenants after termination.  In that case, the employer will need to satisfy the exception for qualified separation pay plans, which will be possible as long as the payments satisfy the limitations applicable to the size and duration of the payments.  More than one exception can be applied to the same agreement, if necessary.  If none of the exceptions are available, the employer will need to satisfy all of the requirements in Section 409A regarding elections, time and form of payment, funding, and otherwise, which are beyond the scope of this article.

Charlie Berquist is a business lawyer with a concentration in executive compensation.  He can be reached at cberquist@bestlaw.com.