Focus on Severance Pay Arrangements Under the New Deferred Compensation Proposed Regulations

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1 11/11/2005 Focus on Severance Pay Arrangements Under the New Deferred Compensation Proposed Regulations The Internal Revenue Service and U.S. Treasury Department recently issued proposed regulations under Section 409A of the Internal Revenue Code dealing with nonqualified deferred compensation plans. It is now very clear that: Severance pay arrangements are covered by Section 409A unless specifically excluded. The proposed regulations would clarify the effect of Section 409A on severance pay arrangements and the exclusions. If a severance pay arrangement covered by Section 409A does not comply with Section 409A s detailed rules governing deferral elections and payment events, employees could face significant IRS penalties. When are these rules effective? For severance pay, Section 409A is generally effective for any rights to severance that arise after December 31, 2004, as well as to any severance pay arrangements that are materially modified after October 3, The earliest that these proposed regulations could become effective is January 1, In the meantime, however, compliance with the proposed regulations will be considered good-faith compliance with Section 409A. While Notice , issued in late December 2004, generally remains in effect until the proposed regulations become effective, the special transition relief for severance pay plans in Notice ends on December 31, Therefore, following the proposed regulations will be the only certain good-faith compliance in Is there any transition relief? The proposed regulations extend certain transition relief that was made available in Notice and some of this relief may be helpful for severance pay arrangements. Most importantly, employers now have until the end of calendar year 2006 to adopt any amendments to their nonqualified deferred compensation plan documents in order to comply with Section 409A, so long as the plans are operated in the meantime in good-faith compliance with Section 409A. Similarly, employers now have until the end of 2006 to amend their nonqualified deferred compensation plans to permit employees to change their deferral elections without violating Section 409A, provided that the deferral elections do not relate to payments that would otherwise have been received during 2006, or cause a payment to be made in 2006 that otherwise would not have been. However, transition relief was not extended in certain other areas. For example, if employers want to amend their nonqualified deferred compensation plans to permit participants to cancel participation or to cancel deferral elections in respect to amounts subject to Section 409A, or to terminate the plans altogether, the deadline for doing so is December 31, Similarly, grandfathered plans not subject to Section 409A must be terminated no later than December 31, 2005 if an employer wishes to do so.

2 How do I know whether a severance pay arrangement is affected? Under the proposed regulations, a severance pay arrangement must comply with Section 409A unless an exemption applies. Severance pay arrangements are divided between arrangements that are triggered by involuntary separations and voluntary separations, with very different rules for each type of separation. Involuntary Separations The primary exemption is for severance pay arrangements that provide payments upon the employee s involuntary termination of employment if: all payments are made by the end of the second year following the year in which the involuntary termination occurs, and the total amount of payments does not exceed two times the lesser of: o the employee s annual compensation for the calendar year preceding the calendar year in which termination occurs; or o the limit on compensation under Code Section 401(a)(17) for the calendar year preceding the calendar year in which termination occurs (the limit is $205,000 for 2004, $210,000 for 2005 and $220,000 for 2006). Example: Mary is involuntarily terminated on November 1, Her compensation for all of 2004 was $220,000. She receives salary continuation payments totaling $300,000 for 24 months. These payments are exempt from Section 409A, as they do not exceed $410,000 (two times the 2004 Section 401(a)(17) limit of $205,000). If Mary were also to receive an additional payment for a release of claims and other consideration, also within the 24-month period, the additional payment could not exceed $110,000. Under the second exemption, if all payments under an involuntary severance pay arrangement are completed by March 15 of the year following the year in which the termination occurs, the arrangement will also be exempt from Section 409A, regardless of the amount of the payments. As a general matter, payments to an employee within 2 ½ months of the end of the year in which the employee earns the payments or the payments are no longer subject to a substantial risk of forfeiture are exempt from Section 409A as short-term deferrals. Terminations during a window program will be treated as involuntary terminations for purposes of Section 409A. A window program is generally defined as an employer-established program that provides severance pay in connection with a termination of employment, for a limited period of time (no greater than one year), for employees who terminate employment during that period or who terminate employment during that period under specified circumstances. The IRS and Treasury Department declined to create a categorical rule governing terminations for good cause or constructive terminations as being involuntary terminations. It is anticipated that a constructive termination will be treated as an involuntary termination only if the individual facts and circumstances clearly warrant. The third exemption is for a collectively bargained separation pay arrangement. The payments may only be made for an actual involuntary separation or under a window program. Voluntary Separation The exemption for severance pay arrangements that provide for payments upon an employee s voluntary termination of employment is much narrower. These arrangements are exempt from Section 409A only if (i) the employer has unfettered discretion to reduce or eliminate the amounts payable under the arrangement at any time, for any reason, or (ii) the employee terminates and

3 all payments under the arrangement are completed within 2½ months after the end of the year in which the employee first acquired a legally binding right to the amounts (i.e., generally, the year in which the arrangement was entered into). Example: In 2005, John and his employer sign an employment agreement under which John can receive severance pay if John voluntarily terminates under specified circumstances. In 2007, John resigns and asks for severance under the agreement. Because John first had a legally binding right in 2005, the payments in 2007 will be treated as deferred compensation. What about reimbursement arrangements? Severance pay arrangements frequently provide for the reimbursement of certain expenses to an employee following a termination. The proposed regulations clarify that reimbursement arrangements are generally exempt from Section 409A provided that all reimbursement payments are made by the end of the second year following the year in which the termination occurs. The exemption only applies to certain types of reimbursable expenses: outplacement expenses, moving expenses, medical expenses, or expenses that would be deductible by the employee as business expenses. In addition, other reimbursements and payments may be made that do not exceed $5,000 in the aggregate. What are the other requirements for severance pay arrangements? Section 409A generally forbids severance benefits to be distributed except upon the occurrence of certain specified events, including a separation from service. Most severance arrangements should already meet this requirement. The proposed regulations also define what qualifies as a separation from service. This definition applies to severance pay and for any other purpose under a deferred compensation plan where a payment is triggered by a separation from service. A separation from service is a death, retirement or termination of employment. A bona fide leave (sick, military or other) is not a termination if the leave is less than six months or, if longer, less than the person s guaranteed rehire period. If a leave with no guaranteed rehire exceeds six months, the separation from service occurs at the end of the six-month period. A termination of employment is generally a facts and circumstances determination. However, the IRS is concerned about situations in which a payment could be either accelerated or deferred based on a termination of employment occurring or not. If a former employee continues to provide services as an independent contractor or otherwise, there is not a termination if the individual provides services at a rate that is 50% or more of the average services provided during the prior 3 calendar years (or total employment term if less), and the annual pay is 50% or more of the individual s average annual pay for the prior 3 calendar years (or total employment term if less). On the deferral side, if an employee purported continues to be an employee but only provides insignificant services, the employee is treated as having a termination of employment. The services are not insignificant if: The individual provides services as an employee at a rate at least 20% of the average rate for the prior 3 calendar years (or total employment term if less); and the annual pay is at least 20% of the average annual pay for the prior 3 calendar years (or total employment term if less). Under Section 409A, if an employee is permitted to make a deferral election in respect to severance payments, generally, this deferral election must be made by the end of the year prior

4 to the year in which the employee acquires a legally binding right to such payments. The proposed regulations, however, clarify that where severance pay due to an involuntary termination is the subject of bona-fide, arms-length negotiations, the deferral election may be made at any time prior to the date on which the employee acquires the legally binding right to the severance payments. Also, like all Section 409A arrangements, a severance pay arrangement must be in writing to comply with Section 409A. What other problems can the new rules cause? One problem applies only to public companies. Section 409A generally forbids deferred compensation to be paid to specified individuals generally the employer s top 50 employees who make $130,000 or more in a year until at least six months after the individual becomes entitled to the payment due to separation from service. Therefore, severance pay arrangements that are not exempt from Section 409A and that cover employees who fall within this definition will have to be amended to postpone commencement of severance payments to these individuals for at least six months after termination of employment. Second, Section 409A also generally forbids any acceleration of severance payments. Any severance pay arrangement that is not exempt from Section 409A and that allows the employer the discretion to accelerate the time or schedule of severance payments would need to be amended to remove this discretion. Third, for Section 409A purposes, similar types of plans are aggregated, such as all account balance plans, and a problem with one aggregated plan affects all of that type of plan. The proposed regulations provide that involuntary severance pay arrangements are a separate type of plan. Therefore, a noncompliant involuntary severance plan would not disqualify any other type of deferred compensation plan. However, a voluntary severance pay plan is lumped with any other plans of the same type, usually other account balance plans. What other types of arrangements are affected by Section 409A? Remember that Section 409A applies to all nonqualified deferred compensation arrangements. This means not only severance pay arrangements, but also any type of nonqualified arrangement that provides for the deferral of compensation, including incentive compensation plans, changeof-control agreements and plans, equity awards (nonstatutory stock options and stock appreciation rights), split-dollar life insurance, and supplementary pension or wrap-401(k) plans. Section 409A generally does not apply to qualified retirement plans (such as 401(k) plans) or to most types of welfare plans (other than severance pay arrangements). What if the rules are violated? Under Section 409A, if a severance pay arrangement that is not exempt from Section 409A does not comply with Section 409A (including noncompliance during 2005), the severance payments for the covered employee become taxable as of the year in which they are no longer subject to a substantial risk of forfeiture. Also, Section 409A imposes an additional 20% penalty tax on these amounts. Finally, the employee will owe interest on these amounts at the current IRS underpayment rate plus 1%. All of the penalties fall on the employee currently. If the employee has nonqualified deferred compensation in other arrangements of a similar type, these amounts would be aggregated and subjected to the penalty tax as well.

5 If you have any questions about Section 409A, or about its impact on severance pay arrangements, please contact a member of the McGuireWoods Employee Benefits Group, including any of the following individuals: Steven D. Kittrell Washington Square 1050 Connecticut Avenue N.W. Suite 1200 Washington, District of Columbia T: F: skittrell@mcguirewoods.com Jeffrey R. Capwell Bank of America Corporate Center 100 North Tryon Street Suite 2900 Charlotte, North Carolina T: F: jcapwell@mcguirewoods.com James C. Williams Of Counsel 77 West Wacker Drive Suite 4100 Chicago, Illinois T: F: jwilliams@mcguirewoods.com G. William Tysse Associate Washington Square 1050 Connecticut Avenue N.W. Suite 1200 Washington, District of Columbia T: F: gtysse@mcguirewoods.com Larry R. Goldstein 77 West Wacker Drive Suite 4100 Chicago, Illinois T: F: lrgoldstein@mcguirewoods.com