New Deferred Compensation Rules: What Closely Held Businesses Should Know about Severance Plans
William N. Anspach, Jr., a Principal in the firm's Business & Finance and Labor & Employment practice groups, heads the Employee Benefits department. He has extensive experience in virtually all areas of employee benefits, including designing and implementing qualified plans, health and welfare plans, executive compensation plans and other deferred compensation programs. Bill can be reached at 312.521.2406 or wanspach@muchshelist.com.
By William N. Anspach, Jr.
December 31, 2006 marks an important deadline for companies with nonqualified deferred compensation plans: compliance with the new rules set forth in Section 409A of the Internal Revenue Code. Deferred compensation, as broadly defined in Section 409A, exists when an employee has a binding right to receive compensation paid in a later year. Many closely held businesses will be surprised to discover that, because of this expanded definition, severance benefits for key executives may fall under these new rules.
Historically, closely held companies have not thought of severance agreements as a type of deferred compensation plan. Unfortunately, the Internal Revenue Service now disagrees. With the compliance deadline for Section 409A looming, it is important to identify and review all severance agreements before the end of 2006. Often difficult to locate, severance agreements may appear in an employment contract, a buy-sell agreement or as a separate plan document. They typically involve extra compensation offered to an employee upon his or her separation from employment—whether resignation, retirement or termination.
While most severance arrangements are covered by Section 409A, there are a few notable exceptions. A severance agreement may be exempt from the new rules if:
- Payments are made due to an involuntary termination (or participation in a reduction-in-force window program) and (a) they are made in full by December 31 of the second year following the year of termination and (b) the amount of severance pay does not exceed the lesser of (i) two times the employee's annual compensation for the prior calendar year; or (ii) two times the annual compensation limit for qualified plans ($220,000 for 2006).
- They are made in full within 2.5 months following the close of the calendar year in which there was an involuntary termination.
The Road to Compliance
What happens if a nonqualified deferred compensation plan fails to meet the new requirements of Section 409A? The employee covered by the plan will be subject to immediate tax, as well as penalties and interest. Specifically, the recipient must claim the compensation as income upon the later of (1) the date the compensation is deferred; or (2) the point at which the compensation is no longer subject to a substantial risk of forfeiture. In addition, the employee could be assessed a penalty totaling 20% of the deferred compensation, plus interest.
The good news for both employers and employees is that severance plans can easily be amended to meet the new requirements of Section 409A. For starters, if certain terms are used in a severance agreement, they should be carefully defined according to the regulations under Section 409A. These terms include "key employee," "change in control" and "termination of employment."
Additionally, a severance plan may not allow employer and employee discretion with respect to the time and form of severance payments. To ensure compliance under this requirement, a closely held business should consider the following:
- Section 409A requires participants to make an irrevocable election to defer compensation prior to the year in which the compensation is earned. However, severance plans, by their nature, do not allow deferral elections in advance. Therefore, severance agreements should establish the time of payment prior to the date the participant obtains a legally binding right to the payments.
- A compliant agreement should also specify the form of payment. In other words, severance plans may no longer permit the employee to select among various distribution options, such as a lump sum or installment payments, at the time of distribution. While the severance plan may allow the employee to make a distribution selection at the time the plan is implemented, it is generally preferable that the form of payment be fixed in the plan document.
- In the past, severance plans have often contained provisions that permitted acceleration of payment of the severance benefit. Except for certain exceptions, such as an event in which a change of control occurs, Section 409A prohibits such acceleration. As a result, this type of provision must be removed from all current and future severance plans.
If you have questions regarding the application of Section 409A to your severance benefit arrangements or other deferred compensation plans, please contact William N. Anspach, Jr. or your Much Shelist attorney.
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