Recently, a client was contemplating whether to terminate a senior management level employee and asked us to review the severance provisions of the employee's employment agreement. We discovered several issues that violated the deferred compensation rules of Internal Revenue Code (Code) section 409A:
- The agreement provided for payment of a lump sum severance benefit if the employer terminated the employee for cause and a series of monthly payments if the employer terminated the employee without cause. Under Code section 409A, there can be only one form of payment for each payment event. In this instance, the payment event was a separation from service (or termination of employment) and the agreement improperly provided for more than one form of payment depending upon whether the separation was with or without cause.
- The agreement provided for the continued payment of salary for a specified period of time if the employee became disabled. The definition of "disabled" in Code section 409A differed significantly from the definition of "disabled" in the agreement.
- The agreement provided that if the employee terminated employment with the employer after reaching age 55, the employer would reimburse the employee for the cost of his health insurance coverage for a period of 36 months. Under Code section 409A, reimbursements must be made by the end of the tax year following the tax year in which the expense was incurred. The agreement did not include this limitation.
Because the agreement did not comply with Code section 409A, we counseled the client that if they proceeded with the termination, the employee would have to pay an additional 20 percent tax (plus applicable interest) on the severance payments. If, however, the client amended the agreement to comply with Code section 409A and delayed the employee's termination for a year, the employee would not have to pay any additional taxes under Code section 409A. IRS guidance regarding the correction of document errors, such as those described above, generally allows correction without payment of 409A taxes if the correction is made more than one year before a payment event occurs under the agreement.
There are numerous other Code section 409A compliance issues that surface in employment and severance agreements.