Severance Plans and Deferred Compensation: The Impact of 409A

Section 409A of the Internal Revenue Code created a new tax regime for deferred compensation plans. Plans that pay severance to employees upon termination of employment may be subject to section 409A, unless the severance plan meets one of the applicable exemptions. In addition, health benefits and other welfare benefits paid for by the employer following an employee's termination could also be subject to section 409A if one of the exemptions does not apply.

There are two important exemptions that apply to certain severance arrangements when an employee is involuntary terminated. One exemption, referred to as the Short-Term Deferral Exemption, applies when the severance payment is conditioned upon involuntary termination, and the payment is made within two and a half months of the end of the year in which the employee is terminated. Another exemption, referred to as the "Two-Times" Exemption, applies when (i) the severance payment is conditioned upon involuntary termination; (ii) the severance payment is made by December 31 of the second year following the year of termination; and (iii) the severance amount does not exceed the lesser of twice the employee's compensation for the previous calendar year, or twice the limit provided for in Section 401(a)(17) (which was $220,000 in 2006).

If your plan does not fall into one of these exemptions for severance payments upon involuntary termination, or if your severance plan provides for severance upon voluntary termination (including termination for good reason), your plan may be subject to section 409A, and you should consult employee benefits counsel to ensure that your plan is in compliance. Employees who receive payments from severance plans that do not comply with section 409A are subject to a 20% tax penalty.