Many executives have employment contracts that provide for severance in the event of an involuntary termination or a termination for "good reason." Public company employers have a limited opportunity to modify the good reason definition before 2009 to make it more likely that severance may be paid upon termination rather than six months later, but such a modification may not be in the employer's or the executive's best interest.
Background
Section 409A of the Internal Revenue Code ("Section 409A") generally treats severance payments as deferred compensation. Unless exempt, severance paid to the top-paid 50 officers of a public company must be delayed for at least six months following the officer's separation from service. If a deferred compensation arrangement is not compliant with Section 409A, income is accelerated to the year the compensation is no longer subject to a substantial risk of forfeiture and the executive is subject to an additional 20 percent tax and, possibly, other penalties.
Exceptions
Certain payments made only as a result of the executive's "involuntary" separation are excepted from the six-month delay.
Regulations under Section 409A, which take effect January 1, 2009, define an involuntary separation as a separation due to the employer's exercise of "unilateral authority," other than due to the executive's request, where the executive was willing and able to continue working. The exception applies only to the extent that payments are made within two years of the involuntary separation and do not exceed two times the lesser of (i) the compensation limit for qualified retirement plans ($230,000 for 2008) or (ii) the executive's annual compensation for the year before the separation.
Good Reason
An otherwise voluntary separation will be treated as involuntary if it is for "good reason," which requires a "material negative change" to the executive's employment relationship. Whether a particular good reason definition satisfies this standard is a factual determination.
For more assurance, parties may utilize a "safe harbor" definition, which requires the following:
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the separation must occur no more than two years following the occurrence (without the executive's consent) of
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a material reduction in (i) the executive's base pay, (ii) the executive's or his or her supervisor's authority, duties or responsibilities (including a requirement that the executive report to a corporate officer or executive instead of to the board), or (iii) the budget over which the executive retains authority;
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a material change in the geographic location at which the executive must perform services; or
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any other material employer breach of the employment agreement;
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the amount, time and form of payment upon separation must be substantially identical to those of any payment upon an actual involuntary separation;
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the executive must notify the employer of the existence of the good reason condition within 90 days after the occurrence; and
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the employer must have at least 30 days to remedy the condition.
Limited Period To Modify Employment Agreements
Employers and executives may modify existing good reason definitions before 2009 to conform to the safe harbor. However, the modification will be successful only if the severance subject to the existing good reason definition is subject to a "substantial risk of forfeiture." That determination will depend on the facts and circumstances.
Before rushing to amend a good reason definition, parties should consider the following:
First, the existing definition, though not a safe harbor, may nevertheless condition payment on a material negative change in the employment relationship and thus comply with the Section 409A standard.
Second, there is no certainty as to how the Internal Revenue Service ("IRS") will interpret the safe harbor. For example, IRS personnel reportedly have said that a 40-mile relocation within the same metropolitan statistical area might not be material, whereas a 40-mile relocation in a less populated area might be material. These factual determinations leave the employer vulnerable to disagreement from executives or the IRS.
Third, the existing definition may be more protective of the executive. For example, the safe harbor only recognizes a material reduction in base pay, not bonus opportunity or other benefits.
Fourth, the specificity of an existing definition may minimize the risk of litigation between the parties. A more specific definition and delayed payment may be preferable, on balance, to a less specific definition and immediate payment.
Fifth, an employer may wish to provide the same severance for other terminations, for example, disability. IRS personnel reportedly have said that if severance may be paid on account of disability, it is not involuntary separation pay.
Finally, any payments subject to the six-month delay may be paid, with interest, at the end of the six-month period.
In any event, this and other Section 409A issues deserve careful consideration in the next few months in order to make appropriate changes to contracts and other agreements by December 31, 2008.
Published July 1, 2008.
