IRS Section 409A applies to deferred compensation arrangements – that is, promises made in one year to pay compensation in a future year. Compensation arrangements subject to Section 409A impose requirements on employers to design and administer a compensation plan in accordance with IRS regulations. There are also significant tax consequences for employees who receive the deferred compensation. The good news is that the IRS has extended the transition period and delayed the effective date of the regulations implementing Section 409A until January 1, 2009. The bad news is that the regulations are fairly complex and time is running out for employers to make any necessary changes to bring employment agreements, bonus plans and any other deferred compensation arrangements into compliance. In addition, there are substantial penalties associated with noncompliance. While this article focuses on separation pay arrangements, 409A’s scope is much broader and potentially applies to any compensation arrangement for which compensation is paid in a subsequent tax year. Accordingly, businesses should consult with a lawyer regarding their particular compensation arrangements, to ensure that they are in full compliance with Section 409A.

Separation pay is compensation that an employee has a right to receive only after termination of the employment relationship. Section 409A applies to a separation pay arrangement that affords an employee a legally binding right to compensation during one tax year that, pursuant to the terms of the arrangement, is or may be payable to the employee in a subsequent tax year. However, there are certain exceptions under which compensation paid in a subsequent tax year will not be considered “deferred compensation” under Section 409A. These exceptions are important, because where the requirements of the exception are met, the employer (and employee) is excused from the onerous requirements of Section 409A. The exceptions are briefly discussed below.

One of the most commonly used exceptions to Section 409A is the short-term deferral exception. This exception applies where the plan or agreement containing the promise to pay does not provide for a deferral, and the employee receives the payment on or before the last day of the applicable 2 ½ month period ending on the later of: (1) the 15th day of the 3rd month following the end of the employee’s 1st tax year in which the right to payment vests (typically March 15th of the following calendar year); or (2) the 15th day of the 3rd month following the end of the employer’s first tax year in which the right to payment vests (typically applicable for employers operating on a fiscal tax year, rather than a calendar tax year).

One tricky aspect of the short-term deferral exception is as follows: If the compensation arrangement calls for a series of payments, some within the short-term deferral period and some after the short-term deferral period, no portion of the series of payments is exempt under the short-term deferral exception. However, one of the other 409A exceptions may be applied to the payments, in which case they will not be deemed to be “deferred compensation” subject to Section 409A.

The other exceptions to 409A are as follows (these exceptions may be used in combination):

• Compensation arrangements which are part of a bona fide collective bargaining agreement;
• Compensation arrangements providing for incidental amounts that do not exceed the limit set forth in IRS Code Section 402(g)($15,500 in 2008);
• Compensation arrangements involving non-taxable benefits, COBRA or expense reimbursements for a limited period for time following separation from service;
• Compensation arrangements involving in-kind benefits for a limited period of time following separation from service; and
• Compensation arrangements providing separation pay (up to limited amounts) resulting from an involuntary separation from service or participation in a “window program.” A “window program” is one that offers benefits for a limited period of time to encourage people to separate from service, such as an early retirement program.

The last exception set forth above merits additional discussion. The exception applies to payments made pursuant to an involuntary separation from service or participation in a window program only where the pay is:

• Payable no later than the end of the employee’s second tax year following the year of separation from service; and
• Limited to an amount that is the lesser of a) two times the employee’s annual rate of compensation for the tax year prior to the tax year in which the separation from service occurs; or b) two times the compensation limit set in IRS Code Section 401(a)(17) for tax-qualified retirement plans ($230,000 in 2008) for the year the separation from service occurs.

Even where the total amount of the payments pursuant to an involuntary separation from service is more than the limit set forth above, the exclusion will continue to apply to payments up to the limitation amount, as long as the payments are made within the required 2- year timeframe.

WHAT EMPLOYERS SHOULD BE DOING IN ANTICIPATION OF THE FINAL 409A REGULATIONS GOING INTO EFFECT

Employers should take the following steps to insure that they are in good faith compliance with Section 409A and poised to be fully compliant with the final regulations when they go into effect on January 1, 2009. First, employers should identify all compensation arrangements that provide for separation pay. Next, employers should have counsel review all separation pay arrangements identified to determine whether they are subject to Section 409A and amend them as necessary to insure compliance with the final regulations. Finally as stated at the beginning of this Update, since the scope of Section 409A is not limited to separation pay arrangements, employers should have counsel review all compensation arrangements involving a promise made during one tax year to pay compensation in a future tax year.