Almost six years have passed since the nonqualified deferred compensation plan rules were enacted by the American Jobs Creation Act of 2004. The Act created new section 409A under the Internal Revenue Code of 1986, as amended. Section 409A mandates specific requirements for nonqualified deferred compensation plans in order for recipients of the deferred compensation to avoid the immediate inclusion in income of vested benefits, the imposition of a 20 percent penalty, and an interest charge.
In general, a nonqualified deferred compensation plan is defined as any plan that provides for the deferral of compensation. A deferral of compensation exists if the service provider has a legally binding right during a tax year to compensation that is or may be payable to the service provider in a later tax year. Since section 409A does not provide for a specific exclusion for separation pay arrangements, the rules and regulations under section 409A can apply to the payment of separation pay. Therefore, companies with separation pay arrangements must determine whether their specific programs provide for the deferral of compensation.
Among other things, section 409A establishes rules detailing (1) when elections to defer compensation have to be made, (2) the time that amounts from nonqualified deferred compensation plans can be distributed, and (3) that plans are not permitted to accelerate distributions. In addition, any payment made under a plan of deferred compensation payable to a specified employee of a publicly traded corporation on account of separation from service may not be paid prior to the end of the six-month period commencing on the date of separation from service.
Under the nonqualified deferred compensation rules, a separation pay arrangement means any arrangement that provides separation pay or, where an arrangement provides both amounts that are separation pay and that are not separation pay, that portion of the arrangement that provides separation pay. Separation pay means any deferral of compensation that will not be paid under any circumstance unless there has been a separation from service, whether voluntary or involuntary, including payments in the form of reimbursement of expenses incurred, and the provision of in-kind benefits. Further, separation pay includes any amounts payable as a result of separation from service, even if such payments are conditioned upon the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirement.
The following separation pay plans do not provide for the deferral of compensation:
1. Separation pay arrangement providing benefits to collectively bargained employees payable pursuant to a collectively bargained agreement upon actual involuntary separation from service or pursuant to a window program.
2. Other separation pay arrangements providing benefits upon actual involuntary separation from service or pursuant to a window program if:
i. The separation pay does not exceed two times the lesser of (A) the sum of the service provider's annual compensation for services provided during the calendar year preceding the calendar year in which the separation from service occurs, or (B) the maximum amount of compensation that may be taken into account for qualified retirement plans under section 401(a)(17) for such year ($245,000 for 2010), and
ii. the separation pay is paid no later than the December 31st of the second calendar year following the calendar year in which occurs the separation from service.
3. A plan to the extent the plan provides separation pay pursuant to the applicable laws of a foreign jurisdiction.
4. And certain reimbursement arrangements, including reimbursements that are otherwise excludible from gross income (reasonable outplacement expenses, moving expenses, medical expenses) and certain in-kind benefits.
A window program is a program established in connection with an impending separation from service to provide separation pay. The program is made available for a limited period of time (no longer than 12 months) to service providers who separate from service during such period of time.
In the case where a service provider has a legally binding right to separation pay, such separation pay will not be treated as the deferral of compensation if the service provider is paid the separation pay within the short-term deferral period. The short-term deferral period is the period ending on the later of the 15th day of the third month following the end of the service provider's first taxable year in which the right to the separation pay is no longer subject to a substantial risk of forfeiture or the 15th day of the third month following the end of the service recipient's first taxable year in which the right to the separation pay is no longer subject to a substantial risk of forfeiture.
Under the rules, if a service provider's entitlement to the separation pay is conditioned on the occurrence of the service provider's involuntary separation from service without cause, the right to such separation pay is subject to a substantial risk of forfeiture. Therefore, the substantial risk of forfeiture does not lapse until the date the service provider incurs the involuntary separation from service.
In general, an involuntary separation from service occurs when the service provider separates from service due to the independent exercise of the service recipient's unilateral authority to terminate the service provider where the service provider was willing and able to continue to provide services. An involuntary separation from service may include the failure of the service recipient to renew a contract at the time such contract expires provided that the service provider was willing and able to execute a new contract.
A voluntary separation from service will be treated as an involuntary separation from service if separation from service occurs during a pre-determined limited period of time (not to exceed two years) as a result of one of the following conditions arising without the service provider's consent:
1. A material diminution in the service provider's base compensation.
2. A material diminution in the service provider's authority, duties, or responsibilities.
3. A material diminution in the authority, duties, or responsibilities of the service provider's supervisor.
4. A material diminution in the budget over which the service provider retains authority.
5. A material change in the geographic location at which the service provider must perform his or her services.
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.
In addition to the above, the amount, time, and form of payment upon separation from service must be substantially identical to the amount, time and form of payment due to actual involuntary separation from service, to the extent such a right exists. Finally, the service provider must be required to provide notice of the existence of the reason for the termination within a period not to exceed 90 days from the date of the existence of the condition and the service recipient, after receiving such notice, must be provided at least 30 days to remedy the condition.
Any amount, or entitlement to any amount due upon separation from service that acts as a substitute for, or a replacement of, amount deferred under a separate nonqualified deferred compensation plan is a payment of deferred compensation.
As companies terminate the employment of employees who are entitled to separation pay, it is important to understand whether the separation pay is deferred compensation subject to section 409A. The following summarize the above rules:
1. If a service provider has a legally binding right to separation pay that is not exempt from section 409A because of the short-term deferral rule or it does not satisfy one of the exception requirements for separation pay, then care has to be taken to ensure that the payment of the benefits is not accelerated or if the payments are to be deferred such deferral complies with the rules under section 409A. In addition, if the service provider is a specified employee of a publicly traded corporation, the commencement date of the separation pay is six months after the date of separation of service.
2. If the separation pay is paid as a result of an involuntary separation from service and under the terms of the arrangement the separation pay will be paid within the short-term deferral period, then the separation pay will not be treated as deferred compensation. On the other hand, if the separation pay will not be paid within the short-term deferral period, then the separation pay plan is a plan of deferred compensation under section 409A and the rules and regulations have to be followed.
3. In the case where separation pay is due upon an actual involuntary separation from service but such separation pay is the subject of bona fide, arm's length negotiations, the service provider does not obtain a legally binding right to the payment until the negotiations are finalized. At that time the determination is made as to whether the separation pay plan is subject to section 409A.
Dennis A. Minich is a Managing Director in the Chicago office of WTAS LLC. With over 34 years of tax experience, he specializes in compensation and employee benefit issues, primarily related to retirement benefit plans, nonqualified plans, employee health and welfare benefits and executive compensation.