C-Level Law

Tax Considerations with Severance Pay: Section 409A

February 17, 2021

When an employer and employee consider entering into an agreement that provides the employee with a right to severance pay (a specified amount of pay upon termination of employment), they should consider the tax implications. As discussed in previous posts, severance pay is common with C-Level Executives, particularly in employment agreements and separation agreements. One key law which should be considered is Section 409A of the Tax Code.

Enacted in 2004, the main purpose of Section 409A was to regulate “deferred compensation.” However, the definition of deferred compensation is broad and, in many cases, will cover severance payments.

There are two primary exceptions to Section 409A, which often apply to severance pay:

• The termination is “involuntary,” the payments do not exceed the lesser of two times the employee’s annual compensation or $580,000 (2021; the limit is usually revised every year), and the payments are completed by the end of the second calendar following the calendar year in which the involuntary termination occurred.
• The termination is involuntary and all payments are made by the 15th day of the third month following the end of the calendar year in which the termination occurred (known as the “short-term deferral exception”).

The applicable definitions are complicated. For example, a resignation for “good reason” (see blog post on Termination of the Employment Relationship) may qualify as an involuntary separation but only if certain conditions are satisfied.

If 409A does apply, then the agreement must comply with 409A’s timing requirements. The payments and the timing of the payments must be set forth in a written agreement which provides that the payments shall be made upon the occurrence of one of the specified reasons:

• Separation from employment;
• The date the employee becomes disabled;
• The employee’s death;
• A specified date or a fixed payment schedule;
• A change in control of an employer company; or
• An unforeseen emergency.

In the context of an employment agreement or separation agreement, a fixed payment schedule is common. A common violation of 409A results from deviating from the fixed payment schedule by paying off the remaining amount contrary to the payment schedule.

Under some circumstances, Section 409A applies to non-monetary benefits, such as healthcare, fringe benefits, and equity.

Failure to comply with 409A can result in severe tax penalties, especially for the employee. A violation results in a 20% penalty on the payment or benefit and taxation in the year in which the payment or benefit vests, not in the year it is received. The 409A regulations are complicated comprising hundreds of pages. Employers and executives should consult competent tax counsel before entering into an agreement providing for significant severance payments or benefits.