Revenue Code (IRC) Sec. 409A sets out rules for nonqualified deferred
compensation (NQDC). Severance pay is included in the definition of NQDC unless
a specific exemption applies.
409A coverage. Sec. 409A defines
"NQDC" as compensation that workers earn in one year but that is not paid
until a future year to the extent that the compensation is not subject to
a substantial risk of forfeiture and not previously included in gross income.
A plan is treated as providing for a payment to be made in a subsequent year
whether the plan explicitly so provides or the deferral condition is inherent
in the terms of the contract. For example, if a plan provides a right to a
payment upon separation from service, the plan generally will result in a
deferral of compensation regardless of whether the employee separates from
service and receives the payment in the same year, because under the plan
the payment is conditioned upon an event that may occur after the year in
which the legally binding right to the payment arises. Sec. 409A does not
apply to qualified plans (such as a 401(k) plan) or to a 403(b) plan or a
Tax penalties. If deferred
compensation covered by Sec. 409A meets the specified requirements, there
is no effect on the employee’s taxes. The compensation is taxed in the same
manner as it would be taxed if it were not covered by Sec. 409A. If the arrangement
does not meet the requirements, the compensation is subject to certain additional
taxes, including a 20 percent additional income tax.
Exception for certain types of separation
pay. IRS regulations (IRS
Reg. Sec. 1.409A-1) provide exceptions from coverage under Sec. 409A
• Certain bona fide collectively bargained arrangements;
• Certain arrangements providing separation pay due solely to an
involuntary separation from service or participation in a window program in
limited amounts and for a limited period of time;
• Certain foreign separation pay arrangements;
• Certain reimbursement arrangements providing for expense reimbursements
or in-kind benefits for a limited period of time following a separation from
• Certain rights to limited amounts of separation pay.
These exceptions from coverage for specified separation pay plans
may be used in combination.
Window program. A "window
program" is a program established by an employer in connection with an impending
separation from service to provide separation pay that is made available for
a limited period of time (no longer than 12 months) to employees who separate
from service during that period or to employees who separate from service
during that period under specified circumstances. A program is not a window
program if an employer establishes a pattern of repeatedly providing for similar
separation pay in similar situations for substantially consecutive, limited
periods of time. Whether the recurrence of these programs constitutes a pattern
is determined on the basis of the facts and circumstances. 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.
Involuntary separation from service
exception. The exception from coverage under Sec. 409A for rights
to payments available only upon an involuntary separation from service or
participation in a window program applies to amounts payable no later than
the end of the second taxable year of the employee following the year of the
separation from service. The payment must be limited to an amount that is
generally the lesser of two times the service provider’s annual compensation
or two times the limit on compensation set in IRC Sec. 401(a)(17) that is $225,000 during 2007.
The exclusion does apply to payments up to the limit, even when the entire
amount of the separation payments exceeds the limit. The right to the payment
up to the applicable limit will not be subject to Sec. 409A, including the
requirement that the payment be delayed for 6 months in the case of a specified
employee, provided that such limited payment is otherwise required to be made,
and is made, no later than the end of the second taxable year following the
service provider’s taxable year in which the separation from service occurs.
This exception does not apply to a plan providing for a payment
on a voluntary separation from service or other event.
Definition of an "involuntary separation
from service." Whether a separation from service is involuntary
is determined based on all the facts and circumstances. Any characterization
of the separation from service as voluntary or involuntary by the employee
and the employer in the documentation relating to the separation from service
is rebuttably presumed to properly characterize the termination. For example,
if a separation from service is characterized as voluntary, the presumption
may be rebutted by demonstrating that if the employee had not voluntarily
resigned, the employer would have terminated him or her. If the right to a
payment is contingent on a voluntary separation from service following an
occurrence that constitutes good reason for termination of the employee's
services, the right may be treated as payable only on an involuntary separation
from service. An involuntary separation may not be devised in order to avoid
the requirements of Sec. 409A.
Safe harbor for good-reason voluntary
separations. IRS regulations also provide a safe harbor under which
a provision for a payment on a voluntary separation from service for good
reason will be treated as providing for a payment on an actual involuntary
separation from service. Those conditions include that:
• The amount is payable only if the employee separates from service
within a limited period of time not to exceed 2 years following the initial
existence of the good-reason condition;
• The amount, time, and form of payment on a voluntary separation
from service for good reason is identical to that for a payment on an involuntary
separation from service;
• The employer provide notice of the existence of the good-reason
condition within 90 days of its initial existence; and
• The employee is provided a period of at least 30 days during
which it may remedy the good-reason condition.
A good-reason condition may consist of one or more of the following
conditions arising without the consent of the employee:
• A material reduction in the employee's base compensation;
• A material reduction in the employee's authority, duties, or
• A material reduction in the authority, duties, or responsibilities
of the employee's supervisor, including a requirement that a supervisor report
to a corporate officer or employee instead of reporting directly to the board
of directors of a corporation or similar entity for organizations that are
• A material reduction in the budget over which the employee retains
• A material change in geographic location at which the employee
must work; or
• Any other action or inaction that constitutes a material breach
of the terms of an applicable employment agreement.
Tax exempt benefits. IRS
regulations provide that a right to a benefit that is excludable from income
will not be treated as a deferral of compensation for purposes of Sec. 409A.
Accordingly, for example, an arrangement to provide health coverage excludable
from income under IRC Sec. 105 generally
would not be subject to Sec. 409A.
Outplacement services and moving expenses. The
reimbursement of certain expenses such as reasonable outplacement expenses
and reasonable moving expenses for a limited period of time due to a separation
from service is not covered by Sec. 409A, whether the separation from service
is voluntary or involuntary. The expense must be incurred by the employee
no later than the end of the second year following the year in which the separation
from service occurs. The period during which an employee can receive a reimbursement
payment is extended to the end of the third year following the separation
from service for reimbursements of expenses incurred by the employee. Reasonable
moving expenses include a reimbursement for a loss incurred selling a primary
Limited payments of separation pay. If
not otherwise excluded, a taxpayer may treat (as excepted from 409A coverage)
a right or rights under a separation pay plan to a payment or payments of
less than the maximum amount of an elective deferral permitted to a 401(k)
plan under IRC 402(g) for
the year of the separation from service. The limited payment exception is
intended to avoid the application of Sec. 409A to incidental benefits often
provided on a separation from service where the parties may not realize that
the benefits are nonqualified deferred compensation. The exclusion may be
applied to any type of separation pay plan but may apply only once with respect
to amounts paid by a service recipient to a service provider.
A NQDC plan or arrangement that does not qualify for an exception
must be in writing and satisfy requirements for:
• The initial deferral election,
• The timing of payments to the employee,
• Acceleration of payments, and
• Subsequent deferral elections.
The material terms of the plan must be specified in the plan
document, and the plan must be operated in accordance with the document. The
material terms of the plan include the amount (or the method or formula for
determining the amount) of deferred compensation, the time and form of payment,
the 6-month payment delay for “key employee” of public companies (if applicable),
and the conditions that apply to any employee elections.
Initial deferral election. In
general, an employee must be required to make the initial election to defer
compensation before the year in which the services are performed for which
the compensation is earned. In an employee’s first year of eligibility under
an NQDC plan or arrangement, he or she may make a deferral election in the
first 30 days of participation. However, the election may apply only to compensation
earned after the election was made. A special provision applies in the case
of an election to defer performance-based compensation that is based on services
performed over 12 months or more. In such a case, the election must be made
no later than 6 months before the end of the performance period.
Timing of payments. Sec.
409A requires that payments of deferred compensation be made at a specified
time or under a fixed schedule that is objectively determinable, or upon the
following events: separation from service, death, disability, change in the
ownership or effective control of the service recipient, or unforeseeable
emergency, as these events are defined in the Sec. 409A regulations.
Anti-acceleration rule. Payments
under an NQDC plan or arrangement generally may not be accelerated. Accelerated
payments that are necessary to comply with a domestic relations order or conflict-of-interest
rules, and upon certain plan terminations, may be permitted.
Subsequent deferral elections. An
NQDC plan that permits an employee to elect to delay or change the form of
a payment must meet the following conditions: (1) the election may not take
effect until at least 12 months after the date on which it was made; (2) if
the election relates to a payment that is not made on account of death, disability,
or unforeseeable emergency, the first payment elected must be deferred for
at least 5 years; and (3) any election related to a payment at a specified
time or under a fixed schedule may not be made less than 12 months before
the date of the first scheduled payment.
Effective dates. IRS has
granted employers an extension to January 1, 2009 to comply with the Sec.
409A regulations that require all nonqualified deferred compensation plans
be in writing and that plan documents be brought into compliance with the
law and regulations.