Severance
Arrangements Under Section 409A
Section
409A was added to the Internal Revenue Code to govern deferred compensation
arrangements effective with respect to all subject benefits that vest on or
after January 1, 2005. Because of the broad sweep of Section 409A, almost
every arrangement that provides compensation to executives and other "service
providers" payable in a form other than basic salary should be reviewed for
compliance purposes. Arrangements subject to Section 409A must be amended
to conform with the recently issued final regulations by no later than the end
of this calendar year. A failure to do so will subject executives covered
by such arrangements to unfavorable tax treatment as of January 1, 2008 (or any
later date when a right to benefits vests) even if the arrangement otherwise
operates in compliance with Section 409A. This means that arrangements
subject to Section 409A must be identified and amended by December 31, 2007.
Additionally, operation of subject "deferred compensation plans" in
compliance with a good faith interpretation of Section 409A is required now and
has been since January 1, 2005.
As
discussed in our Benefits Bulletin on the new Section 409A rules (http://www.benefitslawgroupofchicago.com/HTML/new-deferred-compensation-rules-2005.htm),
all covered compensation arrangements were at that time required to be amended
by December 31, 2006. However, the IRS left several questions unanswered
when prior guidance was issued. These issues have now been addressed by
final regulations issued on April 10, 2007. This bulletin brings you
up-to-date on changes and clarifications of Section 409A, and advises on steps
you must take by the postponed compliance date, December 31, 2007.
The
final Section 409A regulations provide significant clarification relating to
employment agreements and severance arrangements. Under prior IRS
guidance, it was unclear whether or not termination for "good reason" would
be recognized as an "involuntary" termination of employment for purposes of
the "separation pay" exemption from Section 409A discussed below. "Good reason" is frequently included in employment agreements as a trigger
for the payment of severance benefits, and it usually is defined in terms of a
significant reduction in an executive’s authority or duties, a compensation
cutback, or a change in the geographic location of the executive’s place of
employment. The final regulations do recognize "good reason" (as
defined) as an "involuntary" termination of employment. In effect, if
an executive quits for "good reason," this action on the part of the
executive may reflect a constructive termination of employment by the employer.
Severance
arrangements, whether incorporated into employment agreements or otherwise, are
generally subject to Section 409A unless they meet specific exemptions discussed
in the regulations. The most specific exemption carves out from Section
409A compliance those "separation pay" arrangements which meet the following
requirements:
-
The
benefit is payable only on account of an "involuntary" termination of
employment (or a voluntary termination pursuant to a "window plan").
If benefits are not conditioned solely on an involuntary termination of
employment (for example, benefits are payable not only upon termination of
employment but also on account of an "unforeseeable emergency"), the "separation pay" exemption from Section 409A will not be available.
-
The
benefit does not exceed the lesser of two times the employee’s average
annual compensation or the Code Section 401(a)(17) limit on compensation
($225,000 for 2007).
-
The
benefit is paid by no later than December 31 of the second year following
termination of employment.
The
final regulations add the following clarifications to the above rules:
1.
"Involuntary" termination of employment for this purpose includes
termination for "good reason" by an employee where the "good reason"
amounts to a constructive termination of employment by the employer. Such "good reason" must be based on conduct by the employer imposing a
substantial negative change in the employment relationship and is evaluated by
the IRS on a facts and circumstances analysis, unless the safe harbor rules set
out below are followed.
2.
The final regulations provide several criteria for a good reason safe harbor
which, if satisfied, will assure that any amounts paid under the severance
arrangement will be considered payable on account of an "involuntary
termination." Any executive employment agreement that provides the
executive a right to terminate for good reason could be revised in light of
these new safe harbor rules in order to avoid the complication and risk of
Section 409A compliance. The safe harbor criteria include the following
requirements:
-
The
employee must terminate employment within one year following the event
constituting good reason.
-
The
amount, time and form of the benefit must be identical to that available in
the case of a termination by the employer "without cause."
-
The
employee must provide notice to the employer of the existence of a good
reason event within a 90-day period and the employer must have a 30-day cure
period.
-
Good
reason must consist of one or more of six specified circumstances that arise
without the consent of the employee.
3.
"Good reason" for purposes of the above safe harbor includes the following:
-
A
material reduction in the employee’s compensation.
-
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 reports.
-
A
material diminution in the budget over which the employee retains authority.
-
A
material change in geographic location at which the employee is employed.
-
Any
action or inaction by the employer that constitutes a material breach of the
applicable employment agreement.
Note
that "change in control" (as defined) is a separate permissible benefit
trigger under Section 409A, but is not itself a basis for a "good reason"
termination under the regulations.
The
final regulations also elaborate on the following points which impact Section
409A compliance in general and, specifically, non-competition arrangements
providing for deferred payments:
-
A
non-compete agreement (an agreement to refrain from performing services)
will not be sufficient to create a substantial risk of forfeiture for
Section 409A purposes. Consequently, a consulting or other agreement
providing for payment of fees after termination of employment conditioned
only on compliance with a non-compete agreement (in other words, the fees
are paid whether or not any services are actually performed) will cause all
such fees to be fully vested for purposes of Section 409A.
Accordingly, if such an agreement spreads payments over, say, a three year
period, the payments would be deemed fully vested in the first year and
would be taxable in that year along with Section 409A penalties unless the
agreement is Section 409A compliant or otherwise exempt.
-
The
regulations specifically provide that a "savings clause" will not be
effective. The terms of a written arrangement must conform to the
requirements of Section 409A, and a general provision overriding any
non-compliant terms of the arrangement in the event of a conflict with
Section 409A will not be effective to avoid a violation of Section 409A.
Required
Action:
"Deferred
compensation plans" under Section 409A must be amended by the end of this
year. The first step is the identification of subject "plans," which
is defined to include contracts with individual service providers (that is,
employees and independent contractors). Any existing employment agreement
or post-retirement consulting agreement, bonus arrangement, equity incentive
plan, and severance plan as well as any conventional deferred compensation plan
should be reviewed to determine whether it is subject to Section 409A. If
any such arrangement grants a service provider a legally binding right to
compensation that is not currently received but is payable in a later taxable
year, the arrangement will have to comply with Section 409A or establish an
exception to Section 409A compliance. In either case, changes to the
documentation of the arrangement may be required. For example, employment
agreements may be modified to clearly track the good reason safe harbor
exception for "separation pay" plans discussed above. Remember, a
failure to comply may cause the executives who are the intended beneficiaries of
these arrangements to incur tax penalties as of January 1, 2008.
Andrew
S. Williams has practiced in the employee benefits and ERISA arena since ERISA
was passed in 1974. He has been recognized by his peers through a survey
conducted by Leading Lawyers Network as among the top 5 percent of employee
benefit lawyers practicing in
Illinois
. He maintains a website at www.benefitslawgroupofchicago.com with
additional updates, commentary and analysis of benefits and employment topics.
The above material is intended for general information and promotional purposes,
and should not be relied on or construed as professional advice.
Andrew
S. Williams
Aronberg Goldgehn Davis & Garmisa
330 N. Wabash Avenue, Suite 3000
Chicago
,
Illinois
60611
(312) 755-3145
awilliams@agdglaw.com
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