Internal Revenue Code Section 409A introduced new rules governing non-qualified retirement plans and other deferred compensation arrangements. In this series of articles, we take an in-depth look at selected issues under Section 409A.

This article examines methods for providing separation pay consistent with Section 409A, including use of the short-term deferral and safe harbor exceptions, "stacking," and integrating a release of claims. The attached chart provides analysis and options under various sets of circumstances related to separation pay under Section 409A.

There are several options available for providing separation pay consistent with Internal Revenue Code Section 409A. For this purpose, "separation pay" means an amount to which an individual obtains a right to payment only because of his or her separation from service. If the individual has a right to the amount without regard to separation from service, it is not separation pay. For example, amounts payable under the Deferred Compensation Plan are not treated as separation pay because payment of such amounts, once vested, is not contingent on separation from service—they are payable upon death or a fixed time election by the participant.

Separation pay may derive under:

• A separation or negotiated departure agreement, where there was no previous right to separation pay.
• A severance plan or agreement (including any offer letter or employment agreement that provides severance rights).

In the case of a severance plan or agreement, there may be several ways in which the agreement is structured to trigger the separation pay. These are identified in the attached chart.

COMPLIANCE WITH SECTION 409A

There are two mains ways in which separation pay can be structured consistent with Section 409A:

• The separation pay can be structured to avoid Section 409A—that is, structured so that it does not fit the definition of deferred compensation subject to Section 409A. This can be done by structuring the payments to fit within one of the following exceptions to what is considered deferred compensation:
• The short-term deferral exception; or
• The separation pay safe-harbor exception.
• The separation pay can be structured to comply with the rules of Section 409A.

The short-term deferral exception and separation pay safe-harbor exception are described in more detail below.

SHORT-TERM DEFERRAL EXCEPTION

Payments to be made not later than 2½ months after the end of the year in which a "substantial risk of forfeiture" lapses (or, stated differently, after the right to the payment "vests") are not deferred compensation.

Compensation is subject to a substantial risk of forfeiture if:

• The right to payment is conditioned on either the performance of substantial future services (e.g., the employee has to work to get paid) or on the occurrence of a condition related to the purpose of the compensation (e.g., a bonus payable upon achievement of specified goals); and
• There is a real risk that the employee or contractor may not be paid.

Amounts payable upon an "involuntary separation from service" are subject to a substantial risk of forfeiture. A covenant not to compete does not create substantial risk of forfeiture.

An individual is never "vested" before he or she has a right (even if it is a contingent right) to the payment. So, for example, in the case of a negotiated departure where a right to separation pay derives from a contract that was executed around the time of the departure, the right to the payment arises when the contract is executed. Assuming there is no service contingency or other substantial risk of forfeiture, vesting also occurs at the time the contract is executed. A payment that is to be paid within the short-term deferral period measured by reference to the signature date of the contract is not subject to Section 409A. Scenarios are further described in the attached chart.

Separation Pay Safe-Harbor Exception

Any payment that qualifies under the separation pay safe-harbor contained in the Section 409A regulations is not considered to be deferred compensation subject to Section 409A. This exception is available for separation pay that:

• Is paid only in the case of an involuntary termination;
• Does not exceed, in the aggregate, the lesser of:
• twice the employees' annualized compensation for the prior calendar year; or
• twice the compensation limit in effect under Code Section 401(a)(17)—currently, such limit is $245,000 (so twice the limit is $490,000 for 2009).
• Is paid in full by the end of the second calendar year after the separation from service.

An "involuntary termination of employment" includes being fired by the employer, and it also includes a termination instigated by the employee, provided that there is acceptable "good reason" associated with the decision to leave. The regulations have safe-harbor "good reason" standards, and also a general standard if the parties are bold enough to move outside of the safe-harbor.

STACKING BUT NOT SUBSTITUTING

It is perfectly acceptable to "stack" separation pay—that is, it is permissible to have some separation pay fit under the short-term deferral rule, some under the separation pay safe-harbor, and some separation pay that is deferred compensation and structured to comply with Section 409A.

IRS rules, however, prohibit the "substitution" of amounts that are deferred compensation with amounts that are not deferred compensation. This effectively prohibits offset type arrangements where the amount payable as deferred compensation is offset by a variable amount payable under one of the exceptions. For example, an arrangement may provide that a discretionary amount is payable in a lump-sum promptly upon an involuntary termination, and that payment may qualify for the short-term deferral exception. The arrangement may further provide that fixed payments of a defined amount per month will be made over a period of three years after an involuntary termination, and those fixed payments may be structured to comply with Section 409A. (A six-month delay may apply if the recipient is a key employee of a public company.) However, if the arrangement provided that the amount payable as deferred compensation is a gross amount less the discretionary amount paid under the short-term deferral exception, that would be problematic. In that case, the exercise of discretion to increase the short-term deferral amount would have the effect of substituting something that is not deferred compensation for something that is deferred compensation, which would not be permitted under Section 409A.

INTEGRATING A RELEASE OF CLAIMS

Integrating a release of claims as a condition of receiving severance can present administrative issues, particularly for payments designed to fall under the short-term deferral exception. In practice, the employer will want to ensure that employees are given the necessary releases at or shortly after the termination date. This will allow for any applicable consideration periods and rescission periods to run, while still giving the employer time to make the severance payment within the 2½-month short-term deferral window.

The plan or agreement should provide for payments at a fixed time or upon a fixed schedule, subject to the employee signing and not rescinding a release of claims.

COMPLYING WITH SECTION 409A

Separation pay that is deferred compensation must be structured to comply with Section 409A. While the full scope of compliance is not discussed here, most importantly for separation pay, there must be objectively determinable payment dates and payment amounts. Also, for a specified employee of a public company, payments must be delayed for at least six months following separation from service.