Application of Section 409A

Overview of Section 409A? Section 409A imposes complex new requirements on nonqualified deferred compensation plans that must be satisfied to avoid immediate income inclusion (on amounts deferred even if it is not yet received), a 20% additional tax penalty and interest on back taxes at a higher-than-standard rate.

When does Section 409A apply? Section 409A applies, in relevant part, where an employee has a legally binding right to compensation that is not payable until a later year. An employee does not have a legally binding right to compensation if the employer may unilaterally reduce or eliminate the compensation after the services creating the right have been performed. However, the IRS will scrutinize the facts and circumstances of the arrangement to determine whether the employer’s discretion to reduce or eliminate the compensation lacks “substantive significance.” In addition, a right to compensation subject to a contingency will still constitute a legally binding right.

Does Section 409A have special application rules with respect to severance arrangements? Yes, Section 409A has special rules applicable to separation pay plans. A separation pay plan is a plan, including a portion of an agreement with one individual, which defers compensation that is not payable under any circumstances unless the employee has a separation from service, whether voluntary or involuntary. Separation pay does not include compensation that the employee could have received without the termination of employment. An arrangement that defers compensation, such as severance, does not escape the application of Section 409A merely because the right to a payment is conditioned upon a separation from service. However, under IRS regulations, certain types of severance arrangements are specifically exempted from Section 409A.

What type of severance arrangements are exempted from Section 409A? The exceptions include severance arrangements involving “involuntary terminations”, “terminations for good reason”, window programs”, “collectively bargained severance agreements”, “short-term deferrals”, certain “foreign severance arrangements” as well as a catchall exception for a limited amount of severance pay.