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Labor and employment law attorneys may not normally think of severance pay as "deferred compensation." Yet that is the position the Internal Revenue Service has taken in its proposed regulations under Section 409A of the Internal Revenue Code. Accordingly, it is important to understand what Section 409A requires and the potential exemptions available under Section 409A for severance arrangements.

In enacting Section 409A, Congress mandated sweeping new rules for deferred compensation. Deferred compensation is defined to cover the grant in one taxable year of a legally binding right to compensation which is payable in a subsequent taxable year. The proposed regulations provide that, unless an exemption applies, Section 409A covers the following arrangements: (i) cash severance pay; (ii) expense reimbursements (e.g., medical benefits, outplacement expenses, club dues, legal fees, etc.); and (iii) in-kind benefits (e.g., office space, clerical assistance, etc.).

Severance arrangements are potentially subject to Section 409A whether provided only for executives or through a broad-based plan and whether provided in an employment contract, a written policy or plan, or an unwritten arrangement. 409A requires that all arrangements subject to it be in writing.

Because many severance arrangements may have difficulty satisfying Section 409A and because the penalties for noncompliance are so severe, the initial question should be whether one of the Section 409A exemptions is available.

• One potential exemption is for arrangements that do not meet the definition of "deferred compensation." Section 409A defines "deferred compensation" as an arrangement in which the employee "has a legally binding right during a taxable year to compensation that ... is payable .. in a later year." If all severance payments to an employee are made by the end of the year in which the employee obtains a right to the payment, then there is no "deferred compensation." Also, if the employer retains unilateral discretion to reduce or eliminate the severance payments, then the employee has no "legally binding right" to the compensation. In both cases, Section 409A does not apply.
  
  
• A second potential exemption is the "short-term deferral exception," which applies if all payments are made no later than two and one-half (2.5) months after the end of the year (the calendar year or employer's fiscal year, whichever is later) in which the employer's right to the deferred compensation is no longer subject to a "substantial risk of forfeiture" ("SROF"). Generally, a SROF exists if payment is contingent on the performance of significant future services or the occurrence of a condition related to the purpose of the compensation -- and the risk of forfeiture is substantial.
  

  The IRS proposed regulations provide that a right to severance pay that arises only upon involuntary termination generally would qualify as a SROF, thereby making the short-term deferral exception available. Example: a Company enters into a severance agreement with its CFO under which it promises the CFO a severance payment if he is fired. If the CFO is fired during 2007 and the entire severance payment is made by March 15, 2008, Section 409A will not apply because of the short-term deferral exception.

  The IRS's current position is that agreements allowing an executive to receive severance after resigning for "good reason" do not "categorically" create a SROF. Thus, it is not clear what reasons for a resignation the IRS will accept as "good" enough to be a SROF. The IRS may provide guidance on this issue in its final regulations.

  The proposed regulations provide that non-competition and other restrictive covenants do not create a SROF for Section 409A purposes.

• Another potential exemption is available for severance payable in the event of involuntary termination of employment if two conditions are met. First, the amount of severance pay cannot exceed two times the lesser of (i) the employee's total pay during the calendar year before the year of termination; or (ii) the compensation limit under qualified retirement plans ($225,000 in 2007). Second, all payments must be made by the end of the second calendar year following the year in which termination occurs.
  

Severance payments made under a window program (i.e., a program in which employees are offered enhanced benefits if they voluntarily terminate employment during a limited period) are exempt from Section 409A if they satisfy the amount and duration limits in the preceding paragraph. Also, collectively bargained severance plans are exempt if payment is made upon involuntary separation from service or under a window program and the amount and duration limits do not apply.

• The regulations also provide an exemption for reimbursement of certain expenses if they are made over a limited period of time (i.e., by December 31 of the second year following termination of employment). Expense reimbursements available over the employee's lifetime generally are not exempt, although it appears that payments under fully insured medical reimbursement arrangements are exempt. Finally, reimbursements and similar payments are exempt from Section 409A if they do not, in the aggregate, exceed $5,000 during any given year.
  

Unless a severance arrangement falls into one of the foregoing exemptions, Section 409A applies. A detailed explanation of Section 409A's requirements is beyond the scope of this article. The most significant compliance requirements are as follows:
Timing of participant elections. If employees can defer compensation or choose the time or form of payment, these elections generally must be made before the year in which the services generating the deferred compensation are performed. (There is an exception under which an employee negotiating a severance agreement at the time of an involuntary separation may choose among payment options at that time.) If the employer dictates the payment terms without any employee choice, then the time and form of payment must be specified when the employee obtains a legally binding right to payment.

Subsequent elections. Once made, an election (or the terms of an arrangement) regarding the time and form of payment may not be changed unless certain strict conditions are met. For example, a new election can be made only if the original date of payment is delayed at least five years.

Anti-acceleration. Generally, distribution may not be accelerated once payment terms have been set.

Triggering events. Deferred compensation may be paid only upon the following events: (i) "separation from service" (as defined in the regulations), (ii) "change in control" (as defined in the regulations), (iii) "disability" (as defined in the regulations), (iv) "unforeseeable emergency" (as defined in the regulations), (v) at a specified time or under a fixed schedule, and (vi) death.

Six-month delay for key employees. A payment triggered by separation from service and made to a "key employee" of a public company cannot begin until six months after the separation date. Generally, "key employees" are certain shareholders and officers whose annual pay exceeds a dollar limit ($145,000 in 2007). Installment payments affected by this rule may be accumulated and paid in a balloon payment after the six-month period.

Reporting requirements. An often-overlooked Section 409A requirement is that employers must annually report deferred compensation on Form W-2 or 1099 -- even for years before it is taxable to the employee. The IRS has waived the requirement to report deferred compensation for 2005 and 2006, although employers must report amounts that are taxable on account of Section 409A.

The penalties for violating Section 409A are intentionally severe. First, deferred compensation for all taxable years is taxable to the employee in the year of violation. Second, the employee is subject to an excise tax equal to 20% of that taxable amount. Finally, the employee owes interest for underpayment of taxes assuming that the deferred compensation was taxable in the year first deferred.

Section 409A was generally effective January 1, 2005 for deferrals made after December 31, 2004 and for deferrals made before that date that are not "grandfathered." (Generally, amounts deferred and vested as of December 31, 2004 can be exempt under grandfather rules as long as there is no material modification that affects those amounts.) Although the IRS provided limited Section 409A guidance in late 2004 and issued proposed regulations in September, 2005, final regulations are still forthcoming (although expected shortly). For this reason, through the end of 2007, employers may operate their deferred compensation arrangements in "good faith compliance" with Section 409A. Any amendments required to bring arrangements into compliance with Section 409A may be made as late as December 31, 2007.