12
Separation Pay Arrangements
Joseph M. Yaffe
Skadden, Arps, Slate, Meagher & Flom LLP
I.
II.
III.
IV.
Introduction .............................................................................................................
Key Separation Pay Concepts .................................................................................
A. Separation Pay Plan .......................................................................................
B. Separation Pay ...............................................................................................
C. Window Program ...........................................................................................
Application of the Separation Pay Plan and Window Program Exceptions ............
A. Separation Pay Paid Only Upon an Involuntary Termination From Service.
1. Involuntary Separation From Service .....................................................
2. Separation Pay Agreement Entered Into Upon Termination ..................
3. Characterization of Termination by the Parties ......................................
4. Good Reason ...........................................................................................
a. General Requirements ...................................................................
b. Safe Harbor ...................................................................................
5. Amount and Timing Limitations ............................................................
6. Fungibility of Separation Pay .................................................................
B. Window Programs .........................................................................................
C. Stacking..........................................................................................................
D. Substitutions and Replacements ....................................................................
Special Rules and Exceptions ..................................................................................
A. Collectively Bargained Separation Pay Plan Exception ................................
B. Foreign Separation Pay Plan Exception .........................................................
C. Limited Payment Exception ...........................................................................
I.
INTRODUCTION
As discussed in Chapter 2 (Coverage), Section 409A (409A) of the Internal
Revenue Code (Code) can encompass more than just traditional nonqualified deferred
compensation arrangements. Although not immediately obvious at the time 409A was
enacted, it has now become clear that separation pay (essentially, payments made on
account of a termination of service and typically referred to as “severance pay”) can be
subject to 409A. Separation pay differs from traditional deferred compensation in many
respects. In particular, traditional deferred compensation, if not immediately vested at
the time of the deferral, ordinarily vests over a period of time as services are performed.
On the other hand, under many circumstances, separation pay is payable only upon an
involuntary termination of service and thus does not become vested until service
terminates, because it is the termination of service itself that gives rise to the right to
payment. Thus, in many critical ways, separation pay does not have the characteristics of
more traditional deferred compensation, because any deferral period generally does not
begin until the completion of the period of service. Nevertheless, because separation pay
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arrangements may be structured as plans or agreements giving rise to a legally binding
right to payments to be made after the year in which the related services are performed
(as severance often relates to multiple years of service), the regulatory scheme under
409A may extend to a separation pay arrangement.
Determining whether a particular separation pay arrangement is subject to, or
exempt from, 409A is critical to the design, drafting, and implementation of the
arrangement. A separation pay arrangement that is not subject to 409A is not subject to
the many restrictions and limitations under 409A. On the other hand, an arrangement that
is subject to 409A may limit the flexibility of the parties to the arrangement in ways that
were not anticipated by the parties when entering into the arrangement, including, among
other limitations, the imposition of the six-month delay discussed in Chapter 10
(Permissible Payments) and restrictions on the ability of the parties to modify the terms
of the arrangement after it is entered into.
There are several key exclusions to 409A that together will result in many
severance arrangements being excluded from the definition of deferred compensation,
even in light of the broad scope of 409A. The first—the short-term deferral exclusion—
is discussed in detail in Chapter 6 (Short-Term Deferrals). The second—the separation
pay plan exception—is discussed in detail below, in Section III.A. of this chapter. These
two exclusions—together with other exclusions such as the window program exception
and the de minimis exception (both discussed discussed below respectively in Sections
III.B. and IV.C. and various exceptions applicable to reimbursement arrangements
(discussed in Chapter 16 (Reimbursement Arrangements)) can be added together (or
“stacked”) to exclude even more severance payments from 409A, as discussed below in
Section III.C.
II.
KEY SEPARATION PAY CONCEPTS
Separation pay arrangements may be excluded from 409A under several different
rules. One specific exception from 409A’s coverage applies to “separation pay” that is
paid under certain “separation pay plans” or “window programs,” as those terms are
defined in the final regulations. The separation pay plan exception provides that some or
all of separation pay that is payable (a) only due to involuntary separation from service
under a separation pay plan or (b) as a result of voluntary or involuntary participation in a
window program may be exempt from 409A under the separation pay plan or window
program exceptions, to the extent of the applicable limitations on the amount and timing
of the payments under the regulations.
Thus, an understanding of what is meant by “separation pay,” “separation pay
plan,” and “window program” is critical to analyzing a separation pay arrangement under
409A.
A.
Separation Pay Plan
Under the final regulations, a plan that provides for a deferral of compensation
under 409A is not excluded from 409A merely because the right to payment of the
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compensation is conditioned on a separation from service.1 However, separation pay that
is paid under certain separation pay plans is excepted from 409A.2 Under the final
regulations, the term “separation pay plan” is defined broadly to mean any plan that
provides separation pay.3 Where a plan provides for payment of amounts some of which
are separation pay and some of which are not, the portion of the plan that provides for
separation pay constitutes a separation pay plan.4
In practice, the right to separation pay often arises under a separation agreement,
negotiated at the time of departure, where there was no previous right to separation pay
or, alternatively, a severance plan or agreement in existence prior to the time of the
separation from service (including any offer letter, employment agreement, or change in
control plan or agreement that provides for severance rights). In both cases, the relevant
arrangement, plan, or agreement constitutes a separation pay plan to the extent it provides
for payment of separation pay.
Not all payments made under a separation pay plan are excluded from 409A
coverage, as discussed further in this chapter.
B.
Separation Pay
The final regulations define “separation pay” as deferred compensation (as
determined before the application of the separation pay and window program exceptions
discussed in this chapter) to which an individual obtains a right only because of his or her
separation from service, whether voluntary or involuntary.5 The meaning of “separation
from service” under 409A is discussed in detail in Chapter 4 (Other Key Definitions).
For this purpose, in addition to traditional cash severance payments, separation pay may
include payments in the form of reimbursement of incurred expenses and the provision of
in-kind benefits.6 For example, the preamble to the final regulations indicates that the
right to a gross-up payment for taxes payable due to the application of Code section 280G
will constitute separation pay if a separation from service is required to obtain the
payment.7
If an individual has a right to the amount without regard to separation from
service, it is not separation pay for purposes of 409A.8 For example, an amount payable
under a traditional voluntary account balance deferred compensation plan that permits
amounts to be payable on the earlier of a specified time or separation from service is not
treated as separation pay, even if the vested amounts are ultimately paid upon separation
from service. This is because the right to the payment of such amounts, once vested, is
1
Treas. Reg. §1.409A-1(b)(9)(i).
Id.
3
Treas. Reg. §1.409A-1(m).
4
Id.
5
Id.
6
Id.
7
I.R.S., Application of Section 409A to Nonqualified Deferred Compensation Plans, Explanation of
Provisions and Summary of Comments [hereinafter Preamble], §III(J)(1) (first paragraph), 72 Fed. Reg.
19,234, 19,246 (Apr. 17, 2007).
8
Treas. Reg. §1.409A-1(m).
2
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not contingent only on separation from service, since it could have been paid at a
specified time, had that distribution event been triggered prior to a separation from
service.9 The policy rationale for limiting separation pay to payments that are contingent
solely on separation from service is unclear, but the practical impact of the limitation is to
significantly reduce in scope the types of arrangements that may be eligible for the
separation pay plan exception. As a result, this requirement that the separation pay
amount be payable solely on account of separation from service is an important
consideration in determining whether the separation pay plan exception from 409A is
available.
The final regulations expressly provide, however, that an amount does not fail to
qualify as separation pay merely because it is contingent on an employee’s or other
service provider’s10 execution of a release of claims, noncompetition or nondisclosure
requirements, or other similar agreement11 (although the imposition of such a
contingency may raise other issues regarding the timing of the payments, implicating the
time and form of payment rules under 409A, as discussed in Chapter 9 (Changes in Time
and Form of Payment) andChapter 23 (Releases), and, potentially, the timing restrictions
under the separation pay plan exemption, as discussed below in Section III.A.5).
Example 1. An employer maintains a nonqualified deferred compensation
plan pursuant to which participants elect to defer compensation that is distributed
on the earlier of a specified date selected by the participant at the time of her
deferral election or the participant’s separation from service. An employee
separates from service two years after making a deferral election under the plan,
pursuant to which she elected a specified payment date of five years from the date
of her deferral election. The payments to which the employee is entitled upon
separation from service do not constitute separation pay for purposes of 409A
because they could have been paid on the fifth anniversary of the employee’s
deferral election had she not separated from service prior that date and, therefore,
were not solely payable upon her separation from service.12
Example 2. An employer enters into an arrangement with an employee
pursuant to which the employee will receive a specified payment amount upon her
separation from service. The amount is not payable under any other
circumstances. The payment constitutes separation pay when made because it is
payable solely upon separation from service. However, if the employee is entitled
to the payment on account of separation from service for any reason (and not just
an involuntary separation from service), the payment amount will not qualify for
the separation pay plan exception,13 as discussed below in more detail in Section
III.A.
C.
Window Program
9
See id.
Unless stated otherwise, “employee” encompasses “employee or other service provider.”
11
Treas. Reg. §1.409A-1(m).
12
See id.
13
See Treas. Reg. §1.409A-1(b)(9)(iii).
10
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Certain payments of separation pay under a “window program” may be excepted
from 409A. Under the final regulations, a “window program” refers to a program
established by an employer or other service recipient14 in connection with a service
provider’s impending separation from service to provide separation pay, where the
program is made available by the service recipient for a limited period of time (no longer
than 12 months) to service providers who separate from service during that period or to
service providers who separate from service during that period under specified
circumstances.15
The final regulations do not provide any detail on what is meant by an
“impending” separation from service. However, the final regulations do provide that a
program will not be considered a window program if a service recipient establishes a
pattern of repeatedly providing for similar separation pay in similar situations for
substantially consecutive, limited periods of time.16 Whether the recurrence of these
programs constitutes a pattern is determined based on the facts and circumstances.17
Although no one factor is determinative, relevant factors 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.18
Importantly, the definition of window program is not limited to programs under
which separation pay is provided only on account of involuntary separations from
service.19 Indeed, the final regulations are clear that for purposes of determining the
circumstances under which window program payments are not subject to 409A, there is
no requirement that the payments be conditioned on an involuntary separation from
service.20 In addition, the final regulations impose no other eligibility requirements for a
window program, such as a requirement that the program be extended to a minimum
number of service providers.21 However, providing for “one person” or similar smaller
scope window programs containing similar terms to a series of individual service
providers over a period of time could call into question whether the programs taken as
whole are “limited” as required under the final regulations.22 Indeed, based on the
caveats in the final regulations regarding consecutive or unlimited window programs,23
for purposes of 409A, a window program is best thought of as an infrequent limited
program under which eligible service providers may receive separation pay on account of
a program adopted to address unique factors such as a pending or recent significant
corporate transaction or a broad-based reduction in force or voluntary early retirement
program.
14
15
16
17
18
19
20
21
22
23
Unless stated otherwise, “employer” encompasses “employer or other service recipient.”
Treas. Reg. §1.409A-1(b)(9)(vi).
Id.
Id.
Id.
See id.
See Treas. Reg. §1.409A-1(b)(9)(iii).
See id; see also Treas. Reg. §1.409A-1(b)(9)(vi).
See Treas. Reg. §1.409A-1(b)(9)(vi).
See id.
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Example 1. An employer establishes a program pursuant to which, during
a 45-day period, employees who have attained minimum age and service
requirements may separate from service for any reason and receive cash payments
based on their age and service to the company. Eligible employees who do not
elect to participate in the program and separate from service before the 45-day
deadline established by the employer will forfeit the right to receive the cash
payments upon their subsequent separation from service. The program should
qualify as a window program because it is a limited program not offered routinely
by the employer.24
Example 2. The facts assumed are the same as in Example 1 above,
except that the employer determines that it will make the program available
beginning on the first day of each quarter without any specified termination date
for the program. The program likely does not qualify as a window program
because it is not being offered on a limited basis and is available on a
substantially consecutive basis.25
III.
APPLICATION OF THE SEPARATION PAY PLAN AND WINDOW PROGRAM EXCEPTIONS
Some or all of separation pay that is payable (a) only due to an involuntary
separation from service under a separation pay plan or (b) as a result of voluntary or
involuntary participation in a window program may be exempt from 409A under the
separation pay plan or window program exceptions, provided that the severance is paid
pursuant to a program that meets very specific requirements under the final regulations.26
A.
Separation Pay Paid Only Upon an Involuntary Termination From Service
Separation pay (or a portion of separation pay) is exempt from 409A if it is
payable solely on account of an involuntary separation from service (and, as discussed
below in Section III.A.1. could not become payable for any other reason or upon any
other kind of separation from service), if it does not exceed two times the service
provider’s annual compensation (or, if less, two times the Code section 401(a)(17) limit),
and if it is paid no later than the end of the second year following the year of termination.
(Practitioners often refer to this exception as the “2x2 exception,” pronounced “two by
two” or “two times two” as well as the “separation pay exception” or “separation pay
plan exception.”)27
1.
Involuntary Separation From Service
If an amount may become payable for any reason other than an involuntary
separation from service, it is not eligible for the separation pay plan exception.28 As
discussed below in Section III.C. the amount may nonetheless be exempt from 409A by
reason of the application of one of the other exemptions under 409A, most importantly
24
25
26
27
28
See id.
See id.
See Treas. Reg. §1.409A-1(b)(9)(iii).
See id.
Id.
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the short-term deferral exception—discussed in detail in Chapter 6 (Short-Term
Deferrals). With respect to separation pay payable pursuant to the terms of a preexisting
arrangement, as is often the case with employment agreements that provide for severance,
only amounts that are payable under the applicable arrangement solely as a result of
involuntary separation from service may be eligible for the separation pay plan
exception.29 As a result, a payment under an arrangement that provides for separation
pay to be payable both upon a voluntary separation from service for any reason or an
involuntary separation from service without cause or for good reason would not be
eligible for the separation pay plan exception.
The final regulations indicate that whether a specific separation from service is
involuntary is based on a facts and circumstances analysis, and they define involuntary
separation from service as a separation from service due to the “independent exercise of
the unilateral authority” of the service recipient to terminate the services of the service
provider where the service provider was otherwise willing and able to continue
performing services; excluded are circumstances in which the termination of services is
due to the service provider’s implicit or explicit request.30
One type of arrangement that is difficult to analyze under these rules is a plan or
agreement that provides for separation pay upon an involuntary separation from service
without cause, but also provides for payment (of the same or a different amount) upon
termination of employment due to death or disability. The situation is further
complicated where the death or disability entitlement arises under a plan or arrangement
separate from the plan or arrangement that provides for payment upon involuntary
separation from service. If the amount payable upon death or disability is different from
that payable upon an involuntary separation from service without cause or for good
reason, the additional amount payable solely upon involuntary separation from service
would qualify for the separation pay plan exception. But what about an amount that is
payable upon involuntary termination as well as upon termination due to disability or
death? It would appear that termination by reason of disability or due to death should
also be viewed as involuntary termination, such that the payment triggered by these
events qualifies for the separation pay plan exception. Although the issue is far from
clear (in the event of death or disability the service provider is not “able to continue
performing services” as is required by the regulatory definition of an involuntary
separation),31 separations from service on account of death and disability would appear to
be conceptually consistent with the concept of an involuntary separation. In any case,
however, the applicable analysis under the final regulations is far from clear, and this
question therefore remains unresolved.
2.
Separation Pay Agreement Entered Into Upon Termination
In many cases, separation pay is provided pursuant to an agreement entered into at
the time of separation from service. In those circumstances, whether the payment is on
account of an involuntary separation from service must be analyzed based on the facts
29
30
31
See id.
Treas. Reg. §1.409A-1(n)(1).
Id.
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and circumstances of the separation from service,32 as described above. However,
because one of the benefits of the separation pay plan exception from 409A is the
avoidance of the six-month delay (discussed in Chapter 10 (Permissible Payments)), in
the case of a separation pay arrangement entered into at the time of separation, a
practitioner may take a different approach to reach the same result, which is that the sixmonth delay will not apply. Specifically, as described in Chapter 6 (Short-Term
Deferrals), this payment may be a short-term deferral, or, as described in Chapter 10
(Permissible Payments), such a newly implemented arrangement could provide for a
payment on a specified date (as opposed to being triggered by separation from service).
In either case, the six-month delay requirement will not apply.
3.
Characterization of Termination by the Parties
Whether severance is paid under a preexisting arrangement or one that is newly
negotiated at the time of separation from service, it is not uncommon that, even where a
service provider’s separation from service is involuntary from the perspective of all of the
parties involved, the parties nonetheless wish to characterize it as voluntary or mutually
agreed to. In this regard, practitioners must take care with respect to how the separation
from service is characterized in the agreement or otherwise. Under the final regulations,
a characterization of a separation from service as voluntary or involuntary by the service
provider and the service recipient in the severance agreement is presumed to properly
characterize the nature of the separation from service.33 However, this presumption may
be rebutted where the facts and circumstances indicate otherwise.34 The final regulations
provide as an example of an involuntary separation from service one that is designated by
the parties as a voluntary separation from service or resignation but where the facts and
circumstances indicate that, absent such voluntary separation from service, the service
recipient would have terminated the service provider’s services and that the service
provider had knowledge that he or she would be so terminated.35
4.
Good Reason
Often, severance arrangements provide that severance is payable upon an
involuntary separation for service without “cause,” which will constitute an involuntary
separation from service under 409A. It is also common for severance arrangements to
provide for separation pay in connection with a service provider’s voluntary separation
from service under certain circumstances, generally referred to as “good reason.” Under
the final regulations, a voluntary separation from service for “good reason” may be
treated as an involuntary separation from service for purposes of the separation pay plan
exception (as well as for purposes of analyzing the application of the short-term deferral
exception as discussed in Chapter 6 (Short-Term Deferrals)), where the separation occurs
as a result of one or more bona fide conditions that are pre-specified in the arrangement,
32
33
34
35
Id.
Id.
Id.
Id.
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assuming the purpose of permitting payment on the satisfaction of such conditions is not
to avoid the application of 409A.36
a.
General Requirements
The final regulations provide general guidance on what conditions may constitute
satisfactory good reason to separate from service such that the separation from service on
account of such conditions constitutes an involuntary separation from service.37 The
general rule is that these conditions must result in a “material negative change to the
service provider in the service relationship.”38 Examples of such material negative
changes include changes in the duties to be performed, the conditions under which such
duties are to be performed, or the compensation to be received for performing such
services.39 In addition, the final regulations indicate that other factors supporting a
determination that a separation from service for good reason constitutes an involuntary
separation are (1) that the amounts payable upon a separation from service for good
reason are in the same amount and same form as payments available upon an actual
involuntary separation from service and (2) that the service provider is required to give
the service recipient notice of the existence of the condition that would result in good
reason for separation from service and a reasonable opportunity to remedy the
condition.40 Under the final regulations, an involuntary separation from service may also
include termination by reason of the service recipient’s failure to renew a contract at the
time a service provider’s contract expires, provided that the service provider was willing
and able to execute a new contract providing terms and conditions substantially similar to
those in the expiring contract and to continue providing those services.41
b.
Safe Harbor
The proposed regulations did not provide any additional guidance regarding what
specific provisions in a good reason definition would cause it to satisfy the general
requirements described above. Largely in response to practitioner comments regarding
the uncertainty this created, the final regulations included a specific “safe harbor”
definition of good reason that can be relied on to ensure that a voluntary separation from
service will be deemed an involuntary separation from service under 409A.42
To satisfy the safe harbor requirements, the definition of good reason must require
the following:
First, the separation from service must occur during a predetermined limited
period of time not to exceed two years following the initial existence of one or more of
the following conditions arising without the consent of the service provider:43
36
37
38
39
40
41
42
43
Treas. Reg. §1.409A-1(n)(2).
Id.
Id.
Id.
Id.
Treas. Reg. §1.409A-1(n)(1).
See Treas. Reg. §1.409(a)-1(n)(2)(ii).
Treas. Reg. §1.409A-1(n)(2)(ii)(A).
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1. a material diminution in the service provider’s base compensation;44
2. a material diminution in the service provider’s authority, duties, or
responsibilities;45
3. a material diminution in the authority, duties, or responsibilities of the
supervisor to whom the service provider is required to report, including a
requirement that the service provider report to a corporate officer or employee
instead of reporting directly to the board of directors of a corporation (or
similar governing body with respect to an entity other than a corporation);46
4. a material diminution in the budget over which the service provider retains
authority;47
5. a material change in the geographic location at which the service provider
must perform the services;48 and
6. any other action or inaction that constitutes a material breach by the service
recipient of the agreement under which the service provider provides
services.49
Second, the amount, time, and form of payment upon the separation from service
must be substantially identical to the amount, time, and form of payment payable due to
an actual involuntary separation from service, to the extent such a right exists.50
Finally, the service provider must be required to provide notice to the service
recipient of the existence of one or more of the conditions described above within a
period not to exceed 90 days of the initial existence of the condition, and upon notice of
which the service recipient must be provided a period of at least 30 days during which it
may remedy the condition and not be required to pay the amount.51
The general rule and safe harbor provisions in the final regulations have given rise
to significant discussion among practitioners analyzing specific separation pay plan
provisions. The consequences of a “good reason” provision that fails to satisfy the
general rule are significant. When the separation pay provided for under an agreement is
not payable solely on account of an involuntary separation from service, the separation
pay plan exception from 409A is unavailable (even if it is an involuntary termination that
actually triggers severance payment). Likewise, as discussed in Chapter 6 (Short-Term
Deferrals), depending on the extent to which the “good reason” definition fails to qualify
44
45
46
47
48
49
50
51
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(1).
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(2).
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(3).
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(4).
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(5).
Treas. Reg. §1.409A-1(n)(2)(ii)(A)(6).
Treas. Reg. §1.409A-1(n)(2)(ii)(B).
Treas. Reg. §1.409A-1(n)(2)(ii)(C).
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under the general rule, it might not constitute a substantial risk of forfeiture or might
otherwise make the short-term deferral exception unavailable.
A draftsperson seeking certainty with respect to the availability of the separation
pay plan exception would seek to include a “good reason” definition that matches exactly
the safe harbor definition provided in the final regulations. Moreover, some argue,
incorrectly in the opinion of the author, that the failure of a “good reason” definition to
satisfy the safe harbor in every respect will cause it to fail to qualify for purposes of the
separation pay plan exception. If the foregoing were the case, then it would seem that the
inclusion of a general rule in the final regulations would not have been necessary.
Instead, the inclusion of the general rule is ample support that there may be many
circumstances in which a “good reason” definition may not match, in whole or in part,
the language or substance of the safe harbor and yet still qualify for the exception under
the general rule’s standard.
In circumstances in which the general rule is relied on for purposes of the
exception, it is important to analyze each of the conditions imposed under the “good
reason” definition to ensure that they require a material negative change to the service
provider in the service relationship. It should not, however, be viewed as necessary that
every prong of a good reason definition make use of the term “material.” Materiality in
this context will depend on the existing relationship between the service provider and the
service recipient. For example, it not uncommon for a “good reason” provision for a
senior executive officer of a company to make reference to a change in his or her title.
For certain employees, the mere change in his or her title may not give rise, by itself, to a
material negative change to him or her. But for the most senior executives in a company,
having the title of “chief executive officer,” “general counsel,” “chief financial officer,”
or a similar title is often very significant, by itself, to the substance of his or her
relationship with the service recipient. In that circumstance, it may be appropriate to
conclude that any change to the service provider’s title, by itself, constitutes a material
negative change to his or her relationship with the service recipient.
Similarly, in evaluating a “good reason” provision under the general rule, it is
important to read the provisions in the context of “real world” business dealings rather
than focusing on theoretical possibilities. For example, a “good reason” provision may
include a condition that any decrease in base compensation gives rise to “good reason.”
On its face, such a provision would appear to be problematic insofar as it could result in a
service provider separating from service for “good reason” on account of only an
immaterial reduction in base compensation (for example, a reduction of a single dollar).
As a result, some could argue that the provision fails to satisfy the general rule’s
requirement that the condition entail a material negative change.
However, because a scenario of an immaterial reduction in salary is exceedingly
unlikely in the real world, it is not at all clear that the provision fails to satisfy the general
rule. If, in addition, the “good reason” provision includes a requirement that the service
provider give notice of his or her intent to terminate service because of such a reduction
and that the service recipient have an adequate opportunity to remedy the condition, then
depending on the facts and circumstances, it would appear reasonable to conclude that
12-11
any employer acting rationally would always remedy any immaterial reduction in base
compensation, as opposed to permitting the service provider to claim the right to
separation pay (presumably in a far greater amount) on account of the satisfaction of an
immaterial condition. This type of a provision, taken as a whole, would appear to require
a material negative change in the service provider’s relationship before he or she
becomes eligible for separation pay and would thus constitute a qualifying “good reason”
under the general rule.
The analysis should be the same with respect to reductions in incentive
compensation opportunities. In this regard, it is unfortunate that the safe harbor
definition in the final regulations refers to only a material reduction in base salary.
However, for the same reasons that apply in the analysis of a “good reason” definition
that addresses reductions in base salary, a provision tying “good reason” to a reduction in
incentive compensation that is materially adverse to the service provider should
constitute a qualifying “good reason” under the general rule. Representatives of the
Internal Revenue Service and the Treasury Department have informally confirmed this
view in discussions with practitioners. Likewise, the absence of a specific reference to a
“material” reduction should not lead to a different result if the provision, when taken as a
whole with the notice provisions under the definition, would appear to require a material
negative change in the service provider’s relationship with the service recipient.
Alternatively, if the incentive compensation opportunity is written into the contract, a
reduction may qualify as a material breach of contract.
Similarly, it should not be necessary to specify in a particular good reason
definition that all conditions must be materially adverse. For example, it is common to
include a provision triggering good reason upon the relocation of an employee’s principal
place of employment. Often, this condition is described as one with specific geographic
parameters, e.g., a relocation of more than 50 miles or outside a specified geographic
area. It should not be necessary in such situations to also specify that the relocation be a
materially adverse one in addition to satisfying the geographic requirements, provided
that there is an independent basis for concluding that a relocation beyond the geographic
limits specified in the definition would in fact be substantially likely to constitute a
material adverse change. The theoretical possibility (if not foreseen in the facts and
circumstances prevailing when the arrangement was entered into) that the relocation in an
unlikely set of circumstances (for example, relocation in the direction of the service
provider’s residence) could in fact trigger “good reason” without a material adverse
change to the service provider should be disregarded.
In sum, a reasonable “facts and circumstances” analysis should apply to determine
whether a particular good reason definition qualifies as a definition requiring a material
negative change to the service provider’s relationship. If the facts and circumstances of a
“good reason” definition are reasonable when the provision and the agreement within
which it resides are read holistically, practitioners should be able to disregard theoretical
concerns regarding the absence of “magic” language under 409A. Specifically, concerns
over language that may not match exactly the safe harbor definition in the final
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regulations should not lead to an automatic conclusion that the definition is not a
qualifying definition under the general rule.52
5.
Amount and Timing Limitations
Once it has been determined that the payment at issue is payable solely upon an
involuntary separation from service, the analysis must shift to the amount of the
separation pay that is exempt from 409A. Specifically, excluding any amounts provided
under collectively bargained53 and foreign separation pay plans54 and reimbursement
arrangements that are exempt from 409A under the special exemption that applies for
reimbursements provided during a “limited period of time” following separation from
service, as discussed in Chapter 16 (Reimbursement Arrangements), the separation pay or
portion of separation pay exempt from 409A cannot exceed two times the lesser of the
following:
a. the sum of the service provider’s annualized compensation based on the
annual rate of pay for services provided to the service recipient for the service
provider’s taxable year preceding the service provider’s taxable year in which
the service provider separates from service (adjusted for any increase during
that year that was expected to continue indefinitely if the service provider had
not separated from service); 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 in which the service provider
separates from service.55 (For 2010, the applicable limitation under section
401(a)(17) is $245,000.)
Any separation pay in excess of these limitations cannot be exempt from 409A
under the separation pay plan exemption (although it may still be exempt from 409A
under another applicable exception, such as the short-term deferral exception).
Unfortunately, the final regulations do not provide detailed guidance on the
determination of a service provider’s “annualized compensation.” It is not clear from the
final regulations, for example, whether “annualized compensation” is to be determined
based solely on compensation recognized as income for the preceding taxable year (in
which case it would exclude items such as Code section 401(k) and 125 plan deferrals, as
well as amounts that may have been deferred under a traditional deferred compensation
plan), or whether annualized compensation is to be determined without regard to such
deferral amounts. By comparison, the final regulations under the “golden parachute”
provisions of Code section 280G do contain detailed instructions for determining
compensation for purposes of identifying individuals subject to the limitations under
section 280G, and expressly provide that compensation for that purpose is determined
without regard to deferrals under Code sections 125, 132(f)(4), 402(e)(3), and
52
53
54
55
See Treas. Reg. §1.409A-1(n)(1).
Treas. Reg. §1.409A-1(b)(9)(ii).
Treas. Reg. §1.409A-1(b)(9)(iv).
Treas. Reg. §1.409A-1(b)(9)(iii)(A)(2).
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402(h)(1)(B).56 Whether, and how, any equity-based or other long-term incentive awards
are included is also unclear under the 409A final regulations.
Likewise, the final regulations do not include any additional explanation
regarding what is meant by “annual rate of pay” for determining this limitation. Does
“annual rate” of pay mean something different from “actual” pay for the preceding
taxable year (adjusted for increases in pay rate during the year)? In particular, where a
service provider’s compensation for the preceding taxable year comprised both base
compensation and bonus payments, it is difficult to know (unless the bonus payments
were guaranteed) how to reflect bonus eligibility in the service provider’s “annual rate of
pay.” It would appear that a bonus paid with respect to the prior year under a bonus
arrangement that is expected to continue without substantial modification should be
included in the service provider’s annual rate of pay for the purpose of determining the
separation pay plan exemption amount. However, some practitioners dispute this view.
The second requirement relates to timing. The only separation pay or portion of
separation pay that is exempt from 409A under this exception is that which by its terms
must be paid no later than the last day of the service provider’s second taxable year
following the service provider’s taxable year in which the separation from service
occurs.57 For example, if the employee is terminated on June 12, 2010, the amounts that
may be exempt under the separation pay plan exception are only those that must by their
terms be paid not later than December 31, 2012. Thus, the exempt payment period varies
between two and three years depending on when in the year a termination occurs. As
discussed below in Section III.C. when only a portion of the severance is payable within
two years following the termination year, only that portion qualifies for the separation
pay plan exception (although other exceptions may apply to the other portions of
severance).58
Example 1. An employer enters into an arrangement with an employee
pursuant to which the employee will become entitled to 12 months’ base salary
upon her involuntary separation from service at any time. The separation pay
amount will be payable in a lump sum. The employee separates from service in
2010. Her base salary for 2009 (the taxable year preceding her taxable year in
which she separates from service) is $200,000. The entire payment amount is
exempt from 409A under the separation pay plan exception (as well as the shortterm deferral exception).
Example 2. The facts assumed are the same as in Example 1 above,
except that the severance payment is $1 million and the employee’s annualized
compensation is $200,000. Accordingly, $400,000 of the severance will be
exempt from 409A under the separation pay plan exception (i.e., two times the
employee’s annual rate of pay for the preceding taxable year). The remaining
$600,000 will not qualify for the separation pay plan exception (but should be
exempt from 409A under the short-term deferral exception).
56
57
58
Treas. Reg. §1.280G-1, Q&A 21.
Treas. Reg. §1.409A-1(b)(9)(iii)(B).
Treas. Reg. §1.409A-1(b)(9)(iii).
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Example 3. The facts assumed are the same as in Example 1 above,
except that the severance payment is $1 million and the employee’s annualized
compensation is $500,000. Accordingly, $490,000 (two times the Code section
401(a)(17) limit for 2010, the year in which the employee separates from service)
will be exempt from 409A under the separation pay plan exception. The
remaining $510,000 will not qualify for the separation pay plan exception (but
should be exempt from 409A under the short-term deferral exception).
Example 4. An employer enters into an arrangement with an employee
pursuant to which the employee will be entitled to two times her base salary upon
an involuntary separation from service, payable in monthly installments over a
two-year period beginning on her separation from service. At the time of her
separation from service, the employee’s base salary for the taxable year preceding
her taxable year in which she separates from service in 2010 is $200,000. The
entire separation pay amount should be exempt from 409A under the separation
pay plan exception because it satisfies both the amount and timing limitations of
the exception.
Example 5. The facts assumed are the same as in Example 4 above,
except that at the time of her separation from service, the employee’s base salary
for the taxable year preceding her taxable year in which she separates from
service in 2010 is $500,000. Two times the section 401(a)(17) limit for 2010, or
$490,000, of the payment amount is exempt from 409A. The remainder of the
payment amount, or $510,000, will not be exempt under the separation pay plan
exemption, although some of that amount may be exempt under the short-term
deferral exception, as discussed below.
Example 6. The facts assumed are the same as in Example 5 above,
except that the payment amounts will be paid in annual installments of $200,000
each over five years beginning on the employee’s separation from service. The
employee separates from service on June 1, 2010. The first $490,000 of the
installment payments is exempt from 409A because that amount satisfies both the
amount and timing limitations of the separation pay plan exception (because all of
the $490,000 is by its terms payable on or before December 31, 2012). The
remainder of the payment amount, or $510,000, will not be exempt under the
separation pay plan exemption.
Example 7. The facts assumed are the same as in Example 6 above,
except that the payments are to be made in $250,000 installments on each of the
second, third, fourth, and fifth anniversaries of the employee’s separation from
service (that is, on June 1 of 2012, 2013, 2014, and 2015). Only the $250,000
payment made on June 1, 2012, is exempt from 409A because only that amount
satisfies both the amount and timing limitations under 409A (because only
$250,000 is by its terms payable on or before December 31, 2012).
6.
Fungibility of Separation Pay
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As illustrated above, in some circumstances the separation pay plan exemption
applies to only a portion of severance that is paid during the relevant period (because the
amount limitation applies). Often the parties wish to avail themselves of the 409A
exception to avoid the imposition of the six-month delay rule and, thus, apply the
exception to the amounts first paid (so that the six-month delay would not apply to delay
payment of these amounts). The parties may be less concerned about whether later paid
amounts are subject to 409A where those amounts are in any event payable after the sixmonth delay period. However, there is no guidance on which portion of severance is
considered exempt and no apparent requirement to apply the exception to the amounts
first paid, which appears to provide some flexibility.
Example. A severance plan provides for payment of $800,000 payable
over a period of 24 months following termination of employment. Because the
plan does not specify that installment payments will be treated as separate
payments, the short-term deferral exception is not available for any portion of the
severance. The employee’s annualized compensation is $200,000, and his
employment is terminated on December 31, 2010. Of the severance, $400,000
(two times the employee’s annualized compensation) is exempt under 409A. If
the employee is subject to the six-month delay requirement, the parties probably
want to view the $400,000 payable in 2011 as exempt because this would avoid
having to apply the six-month delay to any of the employee’s payments. Suppose,
however, the employee is not subject to the six-month delay or is indifferent to it.
Rather, he would like to accelerate the payment of $400,000 payable in 2012 to be
paid immediately (with the result that all of his severance will be paid in 2011).
Subject to any applicable constructive receipt principles, the $400,000 payable in
2010 is exempt; therefore, no prohibition of acceleration applies to it..
B.
Window Programs
Any portion of separation pay that is payable under a program that satisfies the
requirements of a window program, as discussed above in Section II.C. will be exempt
under 409A to the extent it satisfies the amount and timing limitations applicable to the
separation pay plan exception59 discussed above. in Section III.A. Specifically, amounts
are exempt from 409A to the extent they are paid under a window program, do not
exceed the “two times” requirement as described above in Section III.A.5. and must be
paid within the two-year period following the year of termination60 described above in
Section III.A.5. To the extent that a portion of the payments under a window program
do not satisfy those limitations, they may be subject to 409A, depending on their terms,
and the payments must be analyzed for purposes of 409A’s form and timing of payment
rules, including the satisfaction of the potential six-month delay discussed in Chapter 10
(Permissible Payments) as deferred compensation payments payable upon separation
from service.
It is important to note, however, that the discussion above regarding involuntary
separation from service and “good reason” is not relevant to the analysis of payments
59
60
Treas. Reg. §1.409A-1(b)(9)(iii).
Id.
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under a window program. As indicated above, separation pay satisfying the amount and
timing limitations described above will be exempt from 409A if paid under a window
program, regardless of whether the separation from service triggering the payments is
voluntary or involuntary.61
C.
Stacking
An important consideration in analyzing separation pay arrangements is that the
exceptions from 409A are additive—that is, it is acceptable to “stack” exceptions. The
final regulations and their preamble indicate that the separation pay plan exception
(including the collectively bargained and foreign separation pay plan exceptions and the
special limited time reimbursement exception) may be used in combination with other
exceptions, including the short-term deferral exception.62 Therefore, a portion of a
service provider’s severance may be exempt from 409A under the short-term deferral
rule, a portion may be exempt under the separation pay plan exception, and any
remainder would constitute deferred compensation subject to 409A.63 Appendix ___
illustrates, in the form of a flowchart, how these exceptions interact.
However, care must be taken to ensure that stacking is available, because the
conditions for availability of the exemptions differ. For example, assume a separation
pay plan that provides for separation pay payable in a stream of installments, which, in
the aggregate, exceed the amount limitation discussed above in Section III.A.5. It may be
possible to exempt from 409A a portion of the separation pay under the separation pay
plan exception (specifically that portion that satisfies the amount restriction) and,
separately, the remainder under the short-term deferral exception, such that all of the
payments, when taken together, are exempt from 409A. However, for the short-term
deferral exception to be available for a portion of the separation pay, the installment
payments need to be designated as separate payments as contemplated by the final
regulations and as discussed in Chapters 6 (Short-Term Deferrals) and 9 (Changes in
Time and Form of Payment). If designated as separate payments, each payment could be
considered separately and measured against both the separation pay plan and the shortterm deferral exceptions. The payments paid earliest in the stream may then be more
easily exempted under the short-term deferral exception, and, after subtracting those
payments from the whole for purposes of a 409A analysis, the remaining payments may
fall within the amount limitations of the separation pay plan exemption, as illustrated in
the flowchart in Appendix __.
If a series of installment payments is not designated as a series of separate
payments, then although the separation pay plan exception would continue to apply up to
its applicable amount and timing limitations, the short-term deferral exception would not
be available unless all installment payments were to be made within the applicable shortterm deferral period.64 For this reason, many practitioners believe it is always desirable,
61
See id.
See Treas. Reg. §1.409A-1(b)(9); see also Preamble §III(J)(1) (second paragraph), 72 Fed. Reg. 19,234,
19,246.
63
See Treas. Reg. §1.409A-1(b)(9)(i).
64
Treas. Reg. §1.409A-2(b)(4).
62
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particularly in the context of separation pay plans, to designate each installment payment
as a separate payment as a prophylactic matter (although even if redeferrals of separation
pay amounts in the typical separation pay arrangement are not common, care must still be
taken to understand the implications for making the election for purposes of redeferrals of
amounts that constitute deferred compensation subject to 409A, as discussed in Chapter 9
(Changes in Time and Form of Payment).
Please see Appendix ___ for a detailed flowchart describing how “stacking” may
be used in connection with separation pay arrangements to exempt all or certain portions
of applicable payments from 409A.
Example. An employee is party to a severance agreement that provides
that, upon her involuntary termination of employment without cause, she will
receive aggregate severance payments equal to three times her base salary, which
as of the date of her termination is $400,000. The employee separates from
service without cause on April 1, 2010. The severance payments are payable in
three installments, with the first installment payable upon separation from service
and the remaining two installments payable on the first and second anniversaries
of her separation from service. The severance agreement provides that
installment payments are to be treated as separate payments. The aggregate
severance amount of $1,200,000 would exceed the separation pay plan exemption
limits even though payable within two years from the employee’s separation from
service. However, the first installment payment of $400,000 will be exempt from
409A as a short-term deferral. The entire second installment payment of
$400,000 will be exempt from 409A under the separation pay plan exemption
because it is below the limit on the amount of payment and is payable within two
years from separation from service. Of the third installment payment, $90,000
will be exempt from 409A because it is still within the amount and timing
limitations of the separation pay plan exemption. The remainder of the third
installment payment ($310,000) will be subject to 409A, because it exceeds the
amount limitations under the separation pay plan exemption, but it will qualify as
a compliant payment under 409A because it is paid on a fixed payment date (See
Chapter 10 (Permissible Payments)).
D.
Substitutions
One important factor to consider in structuring a severance arrangement where
there is also a preexisting right to deferred compensation under an arrangement subject to
409A is the prohibition of the “substitution” of amounts that are deferred compensation
for amounts that are not deferred compensation.65 This rule, discussed in more detail in
Chapter 11 (Acceleration of Payments), effectively prohibits offset-type arrangements
where the amount payable as deferred compensation is offset by a variable amount
payable under one of the exceptions, including the separation pay plan exception.66
65
66
See Treas. Reg. §1.409A-3(f).
See id.
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For example, assume that an individual is a party to an employment agreement
providing for a discretionary amount of between $100,000 and $200,000 payable in a
lump sum promptly upon an involuntary separation from service. This payment qualifies
for the separation pay plan exception (or, alternatively, the short-term deferral exception).
The same individual is also entitled to payments of deferred compensation under a
deferred compensation plan subject to 409A. The deferred compensation payments are to
be made in fixed monthly payments over a period of three years after a separation from
service. If either arrangement provides that the amount of deferred compensation
payable would be offset by the discretionary amount paid under the employment
agreement (excluded from 409A under the separation pay plan exception), that would be
problematic. In that case, the exercise of discretion to increase the separation pay plan
amount would have the effect of substituting something that is not deferred compensation
for something that is deferred compensation, which, under 409A, would be an
impermissible acceleration of the scheduled deferred compensation payments.
The final regulations provide more detail on what factors must be considered in
determining whether an impermissible substitution of payments exempt from 409A has
been made for amounts subject to 409A. For example, the final regulations indicate that
if a service provider has a legally binding right to an amount of deferred compensation
payable on a future date that would be forfeited upon separation from service and if the
service provider forfeits this payment but receives a purportedly unrelated separation
payment at separation from service pursuant to a new arrangement, the payment pursuant
to the new arrangement may be viewed as a substitute for the purportedly forfeited
deferred compensation.67 The conclusion depends on the facts and circumstances of the
arrangement.68 However, if the separation from service is voluntary, the final regulations
indicate the payment is presumed to be a payment of the purportedly forfeited deferred
compensation, which is likely to violate the prohibition of acceleration under 409A.69
This presumption may be rebutted by demonstrating that the service provider
would have obtained the right to the payment under the new arrangement regardless of
the forfeiture of the nonvested right.70 In addition, a factor that would support rebuttal of
the presumption is that the amount to which the service provider obtains a right under the
new arrangement is materially less than an amount equal to the present value of the
amount forfeited under the deferred compensation arrangement multiplied by a fraction,
the numerator of which is the period of service the service provider actually completed,
and the denominator of which is the full period of service the service provider would
have been required to complete to receive the full amount of the payment.71 For
example, where a service provider is entitled to a future payment only if the service
provider completes three years of service and at the time of separation from service the
service provider has completed one year of service, the presumption could be rebutted if
the payment to the service provider is materially less than the present value of one-third
of the nonvested amount. The regulations provide no guidance on what “materially less”
67
68
69
70
71
Treas. Reg. §1.409A-1(b)(9)(i).
Id.
Id.
Id.
See id.
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means in this context. Another factor included in the final regulations is that the payment
to the service provider is of a type customarily made to service providers who separate
from service with the service recipient and do not forfeit nonvested rights to deferred
compensation (for example, a payment of accrued but unused leave or a payment for a
release of actual or potential claims).72 Chapter 11 (Acceleration of Payments) discusses
the substitution rules of 409A in detail.
IV.
SPECIAL RULES AND EXCEPTIONS
In addition to the separation pay plan and window program exceptions discussed
above in Section III. there are several other exceptions that may be of more limited
applicability but nonetheless very helpful, when applicable. Specifically, the final
regulations provide exceptions for separation pay plans that are the subject of collective
bargaining without regard to the amount and timing limitations described above.73 In
addition, certain foreign separation pay plans and de minimis separation pay payments
are excepted from 409A.74
A.
Collectively Bargained Separation Pay Plan Exception
A separation pay plan is not subject to 409A to the extent the plan is a collectively
bargained separation pay plan that provides for separation pay only upon an involuntary
separation from service or pursuant to a window program.75 Only the portion of the
separation pay plan attributable to employees covered by a bona fide collective
bargaining agreement is considered to be provided under a collectively bargained
separation pay plan.76 “A collectively bargained separation pay plan is a separation pay
plan that meets the following conditions:”
72
73
74
75
76
77
(A)
The separation pay plan is contained within an agreement that the
Secretary of Labor determines to be a collective bargaining
agreement.
(B)
The separation pay provided by the collective bargaining agreement
was the subject of arm’s length negotiations between employee
representatives and one or more employers, and the agreement
between employee representatives and one or more employers
satisfies [Code] section 7701(a)(46).
(C)
The circumstances surrounding the agreement evidence good faith
bargaining between adverse parties over the separation pay to be
provided under the agreement.77
See id.
See Treas. Reg. §1.409A-1(b)(9)(ii).
See Treas. Reg. §1.409A-1(b)(9)(iv), (v).
Treas. Reg. §1.409A-1(b)(9)(ii).
Id.
Treas. Reg. §1.409A-1(b)(9)(ii)(A)–(C).
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See also the discussion in Chapter 22 (Collectively Bargained Plans). It is important to
note as well that certain terms, such as “separation from service” and “involuntary
separation from service,” have differing definitions for purposes of the collectively
bargained plan exception, as discussed in Chapter 22 (Collectively Bargained Plans).
B.
Foreign Separation Pay Plan Exception
A separation pay plan (including a plan providing payments upon a voluntary
separation from service) is not subject to 409A to the extent the plan provides for
amounts of separation pay required to be provided under the applicable law of a foreign
jurisdiction.78 For this purpose, a provision of foreign law is considered applicable only
to foreign earned income (as defined under Code section 911(b)(1) without regard to
section 911(b)(1)(B)(iv) and without regard to the requirement that the income be
attributable to services performed during the period described in section 911(d)(1)(A) or
(B)) from sources within the foreign country that promulgated such law.79 See also
Chapter 21 (Foreign Plans) for a more detailed discussion of the exception from 409A for
foreign plans generally and its application to foreign separation pay plans.
C.
Limited Separation Payment Exception
A taxpayer may treat a right or rights, if not otherwise excluded, under a
separation pay plan to a payment or payments as not being subject to 409A to the extent
such payments in the aggregate do not exceed the applicable dollar amount under Code
section 402(g)(1)(B) for the year of the separation from service, regardless of whether the
separation from service is voluntary or involuntary.80 (For 2010, the limit is $16,500.)
This amount may be “stacked” with other exceptions, for example , with the separation
pay plan exception, and exceptions for certain reimbursement arrangements discussed in
Chapter 16 (Reimbursement Arrangements).
78
79
80
Treas. Reg. §1.409A-1(b)(9)(iv).
Id.
See Treas. Reg. §1.409A-1(b)(9)(v)(D).
12-21