An executive’s severance benefits under his or her employment agreement are subject to Section 409A of the Code if the severance pay is considered “deferred compensation” under Section 409A. As an executive, you don’t want your severance pay to be subject to Section 409A if you can avoid it because, among other reasons, it’s hard to work with it in a change of control situation. This happens most often in practice where severance pay is not paid in a lump sum within a short period after termination and the execution of a release of claims (generally, before the March 15 of the year following the year of termination - this is commonly referred to as a short-term deferral), but is paid, say, over a period of one or two years after the termination date. Companies may have very legitimate reasons for paying severance pay over a period of years, such as the enforcement of restrictive covenants, like non-competes, over this severance period — so, if the former executive competes with the company, then the company would hold back any remaining severance pay under the employment agreement. This can also happen if the “Good Reason” definition in the agreement is flawed (because “good” 409A severance pay for purposes of the short term deferral can only be payable on an involuntary termination) — a common example that comes up in practice is that the definition does not provide for a notice and cure period for the company upon notice of Good Reason from the executive.
Just a quick word on good-Good Reason: it’s very important to have a qualifying Good Reason definition, which is generally comprised of the following elements: a material diminution in the executive's base compensation, authority, duties or responsibilities (including, as an example, a requirement that a CEO report to a corporate officer rather than reporting directly to the board of directors), a material change in the geographic location where the executive must work, or any other action or inaction by the company that is a material breach of the employment agreement. Also, the conditions alluded to above must be met: the amount, time and form of the payment for Good Reason termination must be substantially identical to payment made on an actual involuntary termination, and the executive must give the company notice of the existence of Good Reason within a relatively short time (typically within 90 days) of the condition first occurring and the company must have some period to cure the alleged Good Reason breach (typically 30 days). So be careful with your Good Reason definitions — you don't want to have too loose a provision where a termination could be properly characterized as a voluntary termination.
Both in the a change of control situation and outside the COC context, companies and executives are relieved when severance pay is exempt from Section 409A and does not involve the “deferral of compensation” under Section 409A, because then the severance pay can be paid out at the time of the COC or the payment obligation could be substituted for another payment under a new agreement. This article will explore what can be done in real life if the severance pay IS considered deferred compensation. First, we will explore the most common ways certain severance pay is exempt from Section 409A.
The short-term deferral rule discussed above is the most common method of avoiding the pitfalls of Section 409A (no six month delay for public company named executive officers too). As noted above, severance pay that, by its terms, can be paid no later than March 15 of the year following the year of termination is generally exempt from Section 409A. The short-term deferral rule applies to lump sum severance pay that can be paid no later than March 15 of the following year and installment payments of severance if the installments are paid by March 15. A practice tip here and a pitfall to avoid: payments of severance under agreements drafted by sophisticated counsel often provide that the payment of severance pay is conditioned on the executive’s release of claims against the company and that the release must become irrevocable within a specified period after the termination date. Some agreements do not provide that the executive must execute the release and the release must become irrevocable within, say, 60 days after his or her termination date. Without an outside date, the IRS could find that the executive had an incentive to “hold” the release agreement until a later calendar year in order to game the timing of the release and therefore the payment of severance into a future calendar year. This can cause the severance payments to fail to qualify under the short-term deferral rule even if the severance is actually paid by March 15 of the following year, unless the severance agreement specifies a deadline by which the release must be signed or the severance is forfeited.
Another pitfall in practice that was very common in the early 2000s but is not too common these days — if the agreement gives an executive a walk-away right for any reason within some window period after a COC, the short-term deferral rule does not apply because the “vesting” of the severance pay occurs and the executive can take a year or more to trigger his or her own payment.
So, what to do if you have an agreement that would subject your severance pay to Section 409A as deferred compensation because, for example, it provides for installment payments beyond March 15? Is all lost? No, not necessarily - here’s where the magic comes in. Stacking exceptions, which means using various exceptions in conjunction with other exemptions:
What about the remainder, if any, of the severance pay that is not captured by 1 and 2 above? It is critically important that this amount be paid in accordance with Section 409A, because this amount is deferred compensation that falls outside the stacking exemptions. Let’s call this left-over amount the Deferred Amount. The Deferred Amount must be paid at the same time and in the same manner as it would have been paid under the original terms of the employment agreement. So the deferred amount has to be paid only after an actual separation from service. This termination of employment can be for any reason, including a voluntary quit, as long as it’s a “separation from service” under Section 409A (and not just after the deal closes). As an example, say the total severance pay amount is $2 million payable over 2 years in equal installments after the executive’s termination. Say the stacking exemptions above exempted $1.5 million of the $2 million severance payment, so the Deferred Amount was $500,000, and the $1.5 million was paid to the executive at the closing of the deal. The Deferred Amount can only be paid in installments, with the date of, and the amounts payable in connection with, such installments determined assuming the following: (i) the entire $2 million severance payment is payable to the executive over the 2 year period in equal installments after his or her separation from service, (ii) the portion of the severance payment attributable to the $1.5 million is payable first, and (iii) payment of the Deferred Amount will start to be paid to the executive only on the date within the 2 year period when the deemed installment payment of the $1.5 million is concluded — so in this example, commencing on the first day of the 18th month after the executive’s termination of employment (i.e., the last six months of the 2 year period after termination).