409A Proposed Regulations on Separation Pay Arrangements

New proposed regulations on Internal Revenue Code Section 409A, which may be relied upon by employers until the effective date of the future final regulations, clarify that separation arrangements, including severance plans, change in control severance agreements, and severance provisions in employment agreements (Separation Pay Arrangements) generally are treated as deferred compensation potentially subject to Code Section 409A even though the right to payment of the compensation is conditioned upon a separation from service.

The following is one of a series of Alerts providing analysis of the proposed regulations. This Alert focuses on Separation Pay Arrangements. Recent Alerts have examined stock option pricing and deferred compensation deadlines, and subsequent Alerts will examine other specific topics covered by the proposed regulations.

Document Compliance Deadline Extended

The proposed regulations extend the deadline for amending nonqualified deferred compensation plans and arrangements for compliance with Code Section 409A until December 31, 2006. In the interim, plans and arrangements must be operated in good faith compliance with Code Section 409A. Notice 2005-1 generally continues to apply until final regulations become effective. In the interim, to the extent any provision of the proposed regulations is inconsistent with a provision of Notice 2005-1, plans may comply with the proposed regulations instead of the Notice. Applying the proposed regulations will be considered good faith compliance.

Practice Tip: Although this extension is a welcome relief for most, employers should, among other steps outlined in our Alert on 2005 deadlines, evaluate severance plans along with employment agreements, change in control agreements and other policies and arrangements that contain severance pay features, because employers have an opportunity in 2005 to terminate these arrangements or take other remedial action that may not be available in 2006.

When Does Code 409A Apply to a Separation Pay Arrangement?

Code Section 409A always applies to a Separation Pay Arrangement unless the arrangement qualifies for an exemption set forth in the guidance. There are four exemptions that employers may qualify for, as follows:

1. Certain Separation Pay Arrangements during 2005

The transition relief in Notice 2005-1 for certain severance arrangements for 2005 continues to apply. Specifically, “severance plans” that are collectively bargained or cover no key employees (as defined in Code Section 416(i) and the related regulations) do not need to comply with 409A in 2005. For this purpose, the term “severance plan” is limited to arrangements that are not contingent upon the service provider’s retirement, do not involve payments that exceed two times the service provider’s annual compensation during the year immediately preceding the termination of service, and complete all payments within 24 months after the service provider’s termination of employment.

2. Short-Term Deferrals

Arrangements that provide for payments upon an involuntary separation and that are structured to meet the requirements of the short-term deferral exception are not required to comply with Code Section 409A. Therefore, if the separation pay is received by the service provider by the later of (a) the 15th day of the third month following the service provider’s first taxable year in which the involuntary separation occurs or (b) the 15th day of the third month following the end of the service recipient’s first taxable year in which involuntary separation occurs, then the arrangement will not be subject to the requirements of Code Section 409A. For example, if the employer has a taxable year ending December 31 and the employee’s employment is terminated involuntarily on December 10, 2006, then the severance arrangement will not be treated as deferred compensation as long as the severance payment is made by March 15, 2007. If the employer has a taxable year ending July 31 and the employee’s employment is terminated involuntarily on November 1, 2006, the arrangement will not be treated as deferred compensation as long as the severance payment is made by October 15, 2007.

3. The Safe Harbor Exemption

Exempt are arrangements providing for separation pay upon an individual’s actual involuntary separation from service or pursuant to a window program if the arrangement provides that the separation pay (not including certain expense reimbursements and in-kind benefits discussed below) does not exceed two times the lesser of:

(a) The sum of the service provider’s annual compensation for services provided to the service recipient as an employee and the service provider’s net earnings from self-employment for services to the service recipient as an independent contractor, both for the calendar year preceding the calendar year in which the separation from service occurs; or

(b) The maximum amount that may be taken into account under a qualified plan pursuant to Code Section 401(a)(17) for the year (for 2005, the limit is $210,000; for 2006, the limit is $220,000); and

(c) The separation pay is paid no later than December 31 of the second calendar year following the calendar year in which the separation from service occurs.

Practice Tip: Arrangements containing "good reason" provisions (as is typical for top executives) may not qualify for either the short-term deferral exemption or the safe harbor exemption because a termination for "good reason" is not an "involuntary" termination. Although the deadline for document compliance with Code Section 409A has been extended until December 31, 2006, employers should evaluate these severance arrangements before December 31, 2005 (i.e., the deadline to revoke an existing arrangement). In 2006, after the transitional relief expires, employers and executives that want to renegotiate may be limited as to the features of the arrangement that can be changed.

Practice Tip: In the case of any Separation Pay Arrangement not exempted from Code Section 409A, it also is important to remember that there must be a six-month delay in any payment upon separation from service to a key employee of a corporation whose stock is publicly traded. Employers should also review these Separation Pay Arrangements prior to December 31, 2005.

4. Union Separation Arrangements

Arrangements for employees covered under a collective bargaining agreement that provide for separation pay upon an involuntary separation from service or pursuant to a window program are also exempt from 409A. In order to meet this exemption:

(a) The Separation Pay Arrangement must be contained within a collective bargaining agreement;

(b) The separation pay is the subject of arm’s-length negotiations between employee representatives and an employer;

(c) The employee representatives involved in the negotiations cannot (i) include any organization in which more than half of the members are owners, officers, or executives of the employer, and (ii) the collective bargaining agreement must be a bona fide agreement between employee representatives and one or more employers; and

(d) The Separation Pay Arrangement must be a result of good faith bargaining between adverse parties over the separation pay to be provided.

What Is a Window Program?

The term “window program” covers a program established by the employer to provide for separation pay in connection with a separation from service for a limited period of time (no greater than one year), to service providers who separate from service during that period. Where an employer establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive limited periods of time, the program will not qualify as a “window program.” Whether a reoccurrence constitutes a pattern is determined based on the facts and circumstances. Relevant factors may include whether the benefits are on account of a specific business event or condition, the degree to which the separation pay relates to the event or condition, and whether the event or condition is temporary or discrete or is a permanent aspect of the employer’s business.

Are Expense Reimbursements and In-Kind Benefits Subject to Code Section 409A?

The proposed regulations provide that certain reimbursement arrangements and in-kind benefits related to a termination of service are not treated as deferred compensation. The limited exemption for these types of arrangements includes amounts that are otherwise excludible from gross income, such as reimbursements for business expenses, outplacement expenses, or moving expenses, as well as other payments that do not exceed a de minimus amount of $5,000 in the aggregate during any taxable year, as long as these amounts are actually incurred and directly related to the termination of service and are paid by December 31 of the second calendar year following the calendar year in which the separation from service occurs.

Can an Employer Substitute a Severance Arrangement for Other Payments to Avoid 409A?

No, the requirements of Code Section 409A cannot be avoided by substituting or replacing payments under a nonqualified deferred compensation plan with a Separation Pay Arrangement. The substitute or replacement payments still will be treated as nonqualified deferred compensation.

How Does Code Section 409A Affect Separation Agreements Entered into in Connection with Termination?

For separation pay that is negotiated (in a bona fide arm’s-length negotiation) at the time of an involuntary termination, the election as to the time and form of payment may be made on or before the date the service provider obtains a legally binding right to payment. In the case of separation pay due to participation in a window program, the initial deferral election can be made at any time up to the time the election to participate in the window program becomes irrevocable.

Will a 409A Failure with Regard to a Separation Pay Arrangement Subject to 409A Result in a Failure under Any Other Nonqualified Plan?

No. The proposed regulations provide an additional separate type of plan for purposes of the plan aggregation rules. In addition to account balance plans, nonaccount balance plans, and equity-based compensation arrangements, the regulations create a new category for Separation Pay Arrangements and window programs. With this new category, all amounts deferred with respect to a service provider under all Separation Pay Arrangements of the service recipient due to an involuntary termination or participation in a window program are aggregated together, and will not be aggregated with account balance plans, nonaccount balance plans or equity-based compensation agreements under Code Section 409A. As discussed above, a Separation Pay Arrangement that provides for payment on termination of an employee for "good reason" will not be treated as providing for payment on "involuntary" termination, and such an arrangement may have to be aggregated with other deferred compensation plans covering the employee.

What Should I Do Now?

Carefully review your company’s Severance Pay Arrangements. If you believe that you have Severance Pay Arrangements that are subject to Code Section 409A, please call your DLA Piper Rudnick Gray Cary US LLP contact or

Richard W. Ashley III

Michael T. Frank

William H. Hoffman

Joseph A. (Tony) Hugg

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