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Separation Pay Arrangements Joseph M. Yaffe Skadden, Arps, Slate, Meagher & Flom LLP

I. Introduction ............................................................................................................. II. Key Separation Pay Concepts .................................................................................

A. Separation Pay Plan ....................................................................................... B. Separation Pay ............................................................................................... C. Window Program ...........................................................................................

III. Application of the Separation Pay Plan and Window Program Exceptions ............ A. Separation Pay Paid Only Upon an Involuntary Termination From Service .

1. Involuntary Separation From Service ..................................................... 2. Separation Pay Agreement Entered Into Upon Termination .................. 3. Characterization of Termination by the Parties ...................................... 4. Good Reason ...........................................................................................

a. General Requirements ................................................................... b. Safe Harbor ...................................................................................

5. Amount and Timing Limitations ............................................................ 6. Fungibility of Separation Pay .................................................................

B. Window Programs ......................................................................................... C. Stacking.......................................................................................................... D. Substitutions and Replacements ....................................................................

IV. Special Rules and Exceptions .................................................................................. A. Collectively Bargained Separation Pay Plan Exception ................................ B. Foreign Separation Pay Plan Exception ......................................................... C. Limited Payment Exception ...........................................................................

I. INTRODUCTION

As discussed in Chapter 2 (Coverage), Section 409A (409A) of the Internal Revenue Code (Code) can encompass more than just traditional nonqualified deferred compensation arrangements. Although not immediately obvious at the time 409A was enacted, it has now become clear that separation pay (essentially, payments made on account of a termination of service and typically referred to as “severance pay”) can be subject to 409A. Separation pay differs from traditional deferred compensation in many respects. In particular, traditional deferred compensation, if not immediately vested at the time of the deferral, ordinarily vests over a period of time as services are performed. On the other hand, under many circumstances, separation pay is payable only upon an involuntary termination of service and thus does not become vested until service terminates, because it is the termination of service itself that gives rise to the right to payment. Thus, in many critical ways, separation pay does not have the characteristics of more traditional deferred compensation, because any deferral period generally does not begin until the completion of the period of service. Nevertheless, because separation pay

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arrangements may be structured as plans or agreements giving rise to a legally binding right to payments to be made after the year in which the related services are performed (as severance often relates to multiple years of service), the regulatory scheme under 409A may extend to a separation pay arrangement.

Determining whether a particular separation pay arrangement is subject to, or exempt from, 409A is critical to the design, drafting, and implementation of the arrangement. A separation pay arrangement that is not subject to 409A is not subject to the many restrictions and limitations under 409A. On the other hand, an arrangement that is subject to 409A may limit the flexibility of the parties to the arrangement in ways that were not anticipated by the parties when entering into the arrangement, including, among other limitations, the imposition of the six-month delay discussed in Chapter 10 (Permissible Payments) and restrictions on the ability of the parties to modify the terms of the arrangement after it is entered into.

There are several key exclusions to 409A that together will result in many severance arrangements being excluded from the definition of deferred compensation, even in light of the broad scope of 409A. The first—the short-term deferral exclusion—is discussed in detail in Chapter 6 (Short-Term Deferrals). The second—the separation pay plan exception—is discussed in detail below, in Section III.A. of this chapter. These two exclusions—together with other exclusions such as the window program exception and the de minimis exception (both discussed discussed below respectively in Sections III.B. and IV.C. and various exceptions applicable to reimbursement arrangements (discussed in Chapter 16 (Reimbursement Arrangements)) can be added together (or “stacked”) to exclude even more severance payments from 409A, as discussed below in Section III.C.

II. KEY SEPARATION PAY CONCEPTS

Separation pay arrangements may be excluded from 409A under several different rules. One specific exception from 409A’s coverage applies to “separation pay” that is paid under certain “separation pay plans” or “window programs,” as those terms are defined in the final regulations. The separation pay plan exception provides that some or all of separation pay that is payable (a) only due to involuntary separation from service under a separation pay plan or (b) as a result of voluntary or involuntary participation in a window program may be exempt from 409A under the separation pay plan or window program exceptions, to the extent of the applicable limitations on the amount and timing of the payments under the regulations.

Thus, an understanding of what is meant by “separation pay,” “separation pay plan,” and “window program” is critical to analyzing a separation pay arrangement under 409A.

A. Separation Pay Plan

Under the final regulations, a plan that provides for a deferral of compensation under 409A is not excluded from 409A merely because the right to payment of the

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compensation is conditioned on a separation from service.1 However, separation pay that is paid under certain separation pay plans is excepted from 409A.2 Under the final regulations, the term “separation pay plan” is defined broadly to mean any plan that provides separation pay.3 Where a plan provides for payment of amounts some of which are separation pay and some of which are not, the portion of the plan that provides for separation pay constitutes a separation pay plan.4

In practice, the right to separation pay often arises under a separation agreement, negotiated at the time of departure, where there was no previous right to separation pay or, alternatively, a severance plan or agreement in existence prior to the time of the separation from service (including any offer letter, employment agreement, or change in control plan or agreement that provides for severance rights). In both cases, the relevant arrangement, plan, or agreement constitutes a separation pay plan to the extent it provides for payment of separation pay.

Not all payments made under a separation pay plan are excluded from 409A coverage, as discussed further in this chapter.

B. Separation Pay

The final regulations define “separation pay” as deferred compensation (as determined before the application of the separation pay and window program exceptions discussed in this chapter) to which an individual obtains a right only because of his or her separation from service, whether voluntary or involuntary.5 The meaning of “separation from service” under 409A is discussed in detail in Chapter 4 (Other Key Definitions). For this purpose, in addition to traditional cash severance payments, separation pay may include payments in the form of reimbursement of incurred expenses and the provision of in-kind benefits.6 For example, the preamble to the final regulations indicates that the right to a gross-up payment for taxes payable due to the application of Code section 280G will constitute separation pay if a separation from service is required to obtain the payment.7

If an individual has a right to the amount without regard to separation from service, it is not separation pay for purposes of 409A.8 For example, an amount payable under a traditional voluntary account balance deferred compensation plan that permits amounts to be payable on the earlier of a specified time or separation from service is not treated as separation pay, even if the vested amounts are ultimately paid upon separation from service. This is because the right to the payment of such amounts, once vested, is 1 Treas. Reg. §1.409A-1(b)(9)(i). 2 Id. 3 Treas. Reg. §1.409A-1(m). 4 Id. 5 Id. 6 Id. 7 I.R.S., Application of Section 409A to Nonqualified Deferred Compensation Plans, Explanation of Provisions and Summary of Comments [hereinafter Preamble], §III(J)(1) (first paragraph), 72 Fed. Reg. 19,234, 19,246 (Apr. 17, 2007). 8 Treas. Reg. §1.409A-1(m).

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not contingent only on separation from service, since it could have been paid at a specified time, had that distribution event been triggered prior to a separation from service.9 The policy rationale for limiting separation pay to payments that are contingent solely on separation from service is unclear, but the practical impact of the limitation is to significantly reduce in scope the types of arrangements that may be eligible for the separation pay plan exception. As a result, this requirement that the separation pay amount be payable solely on account of separation from service is an important consideration in determining whether the separation pay plan exception from 409A is available.

The final regulations expressly provide, however, that an amount does not fail to qualify as separation pay merely because it is contingent on an employee’s or other service provider’s10 execution of a release of claims, noncompetition or nondisclosure requirements, or other similar agreement11 (although the imposition of such a contingency may raise other issues regarding the timing of the payments, implicating the time and form of payment rules under 409A, as discussed in Chapter 9 (Changes in Time and Form of Payment) andChapter 23 (Releases), and, potentially, the timing restrictions under the separation pay plan exemption, as discussed below in Section III.A.5).

Example 1. An employer maintains a nonqualified deferred compensation plan pursuant to which participants elect to defer compensation that is distributed on the earlier of a specified date selected by the participant at the time of her deferral election or the participant’s separation from service. An employee separates from service two years after making a deferral election under the plan, pursuant to which she elected a specified payment date of five years from the date of her deferral election. The payments to which the employee is entitled upon separation from service do not constitute separation pay for purposes of 409A because they could have been paid on the fifth anniversary of the employee’s deferral election had she not separated from service prior that date and, therefore, were not solely payable upon her separation from service.12

Example 2. An employer enters into an arrangement with an employee pursuant to which the employee will receive a specified payment amount upon her separation from service. The amount is not payable under any other circumstances. The payment constitutes separation pay when made because it is payable solely upon separation from service. However, if the employee is entitled to the payment on account of separation from service for any reason (and not just an involuntary separation from service), the payment amount will not qualify for the separation pay plan exception,13 as discussed below in more detail in Section III.A.

C. Window Program 9 See id. 10 Unless stated otherwise, “employee” encompasses “employee or other service provider.” 11 Treas. Reg. §1.409A-1(m). 12 See id. 13 See Treas. Reg. §1.409A-1(b)(9)(iii).

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Certain payments of separation pay under a “window program” may be excepted from 409A. Under the final regulations, a “window program” refers to a program established by an employer or other service recipient14 in connection with a service provider’s impending separation from service to provide separation pay, where the program is made available by the service recipient for a limited period of time (no longer than 12 months) to service providers who separate from service during that period or to service providers who separate from service during that period under specified circumstances.15

The final regulations do not provide any detail on what is meant by an “impending” separation from service. However, the final regulations do provide that a program will not be considered a window program if a service recipient establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time.16 Whether the recurrence of these programs constitutes a pattern is determined based on the facts and circumstances.17 Although no one factor is determinative, relevant factors include whether the benefits are on account of a specific business event or condition, the degree to which the separation pay relates to the event or condition, and whether the event or condition is temporary or discrete or is a permanent aspect of the employer’s business.18

Importantly, the definition of window program is not limited to programs under which separation pay is provided only on account of involuntary separations from service.19 Indeed, the final regulations are clear that for purposes of determining the circumstances under which window program payments are not subject to 409A, there is no requirement that the payments be conditioned on an involuntary separation from service.20 In addition, the final regulations impose no other eligibility requirements for a window program, such as a requirement that the program be extended to a minimum number of service providers.21 However, providing for “one person” or similar smaller scope window programs containing similar terms to a series of individual service providers over a period of time could call into question whether the programs taken as whole are “limited” as required under the final regulations.22 Indeed, based on the caveats in the final regulations regarding consecutive or unlimited window programs,23 for purposes of 409A, a window program is best thought of as an infrequent limited program under which eligible service providers may receive separation pay on account of a program adopted to address unique factors such as a pending or recent significant corporate transaction or a broad-based reduction in force or voluntary early retirement program. 14 Unless stated otherwise, “employer” encompasses “employer or other service recipient.” 15 Treas. Reg. §1.409A-1(b)(9)(vi). 16 Id. 17 Id. 18 Id. 19 See id. 20 See Treas. Reg. §1.409A-1(b)(9)(iii). 21 See id; see also Treas. Reg. §1.409A-1(b)(9)(vi). 22 See Treas. Reg. §1.409A-1(b)(9)(vi). 23 See id.

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Example 1. An employer establishes a program pursuant to which, during a 45-day period, employees who have attained minimum age and service requirements may separate from service for any reason and receive cash payments based on their age and service to the company. Eligible employees who do not elect to participate in the program and separate from service before the 45-day deadline established by the employer will forfeit the right to receive the cash payments upon their subsequent separation from service. The program should qualify as a window program because it is a limited program not offered routinely by the employer.24

Example 2. The facts assumed are the same as in Example 1 above, except that the employer determines that it will make the program available beginning on the first day of each quarter without any specified termination date for the program. The program likely does not qualify as a window program because it is not being offered on a limited basis and is available on a substantially consecutive basis.25

III. APPLICATION OF THE SEPARATION PAY PLAN AND WINDOW PROGRAM EXCEPTIONS

Some or all of separation pay that is payable (a) only due to an involuntary separation from service under a separation pay plan or (b) as a result of voluntary or involuntary participation in a window program may be exempt from 409A under the separation pay plan or window program exceptions, provided that the severance is paid pursuant to a program that meets very specific requirements under the final regulations.26

A. Separation Pay Paid Only Upon an Involuntary Termination From Service

Separation pay (or a portion of separation pay) is exempt from 409A if it is payable solely on account of an involuntary separation from service (and, as discussed below in Section III.A.1. could not become payable for any other reason or upon any other kind of separation from service), if it does not exceed two times the service provider’s annual compensation (or, if less, two times the Code section 401(a)(17) limit), and if it is paid no later than the end of the second year following the year of termination. (Practitioners often refer to this exception as the “2x2 exception,” pronounced “two by two” or “two times two” as well as the “separation pay exception” or “separation pay plan exception.”)27

1. Involuntary Separation From Service

If an amount may become payable for any reason other than an involuntary separation from service, it is not eligible for the separation pay plan exception.28 As discussed below in Section III.C. the amount may nonetheless be exempt from 409A by reason of the application of one of the other exemptions under 409A, most importantly 24 See id. 25 See id. 26 See Treas. Reg. §1.409A-1(b)(9)(iii). 27 See id. 28 Id.

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the short-term deferral exception—discussed in detail in Chapter 6 (Short-Term Deferrals). With respect to separation pay payable pursuant to the terms of a preexisting arrangement, as is often the case with employment agreements that provide for severance, only amounts that are payable under the applicable arrangement solely as a result of involuntary separation from service may be eligible for the separation pay plan exception.29 As a result, a payment under an arrangement that provides for separation pay to be payable both upon a voluntary separation from service for any reason or an involuntary separation from service without cause or for good reason would not be eligible for the separation pay plan exception.

The final regulations indicate that whether a specific separation from service is involuntary is based on a facts and circumstances analysis, and they define involuntary separation from service as a separation from service due to the “independent exercise of the unilateral authority” of the service recipient to terminate the services of the service provider where the service provider was otherwise willing and able to continue performing services; excluded are circumstances in which the termination of services is due to the service provider’s implicit or explicit request.30

One type of arrangement that is difficult to analyze under these rules is a plan or agreement that provides for separation pay upon an involuntary separation from service without cause, but also provides for payment (of the same or a different amount) upon termination of employment due to death or disability. The situation is further complicated where the death or disability entitlement arises under a plan or arrangement separate from the plan or arrangement that provides for payment upon involuntary separation from service. If the amount payable upon death or disability is different from that payable upon an involuntary separation from service without cause or for good reason, the additional amount payable solely upon involuntary separation from service would qualify for the separation pay plan exception. But what about an amount that is payable upon involuntary termination as well as upon termination due to disability or death? It would appear that termination by reason of disability or due to death should also be viewed as involuntary termination, such that the payment triggered by these events qualifies for the separation pay plan exception. Although the issue is far from clear (in the event of death or disability the service provider is not “able to continue performing services” as is required by the regulatory definition of an involuntary separation),31 separations from service on account of death and disability would appear to be conceptually consistent with the concept of an involuntary separation. In any case, however, the applicable analysis under the final regulations is far from clear, and this question therefore remains unresolved.

2. Separation Pay Agreement Entered Into Upon Termination

In many cases, separation pay is provided pursuant to an agreement entered into at the time of separation from service. In those circumstances, whether the payment is on account of an involuntary separation from service must be analyzed based on the facts 29 See id. 30 Treas. Reg. §1.409A-1(n)(1). 31 Id.

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and circumstances of the separation from service,32 as described above. However, because one of the benefits of the separation pay plan exception from 409A is the avoidance of the six-month delay (discussed in Chapter 10 (Permissible Payments)), in the case of a separation pay arrangement entered into at the time of separation, a practitioner may take a different approach to reach the same result, which is that the six-month delay will not apply. Specifically, as described in Chapter 6 (Short-Term Deferrals), this payment may be a short-term deferral, or, as described in Chapter 10 (Permissible Payments), such a newly implemented arrangement could provide for a payment on a specified date (as opposed to being triggered by separation from service). In either case, the six-month delay requirement will not apply.

3. Characterization of Termination by the Parties

Whether severance is paid under a preexisting arrangement or one that is newly negotiated at the time of separation from service, it is not uncommon that, even where a service provider’s separation from service is involuntary from the perspective of all of the parties involved, the parties nonetheless wish to characterize it as voluntary or mutually agreed to. In this regard, practitioners must take care with respect to how the separation from service is characterized in the agreement or otherwise. Under the final regulations, a characterization of a separation from service as voluntary or involuntary by the service provider and the service recipient in the severance agreement is presumed to properly characterize the nature of the separation from service.33 However, this presumption may be rebutted where the facts and circumstances indicate otherwise.34 The final regulations provide as an example of an involuntary separation from service one that is designated by the parties as a voluntary separation from service or resignation but where the facts and circumstances indicate that, absent such voluntary separation from service, the service recipient would have terminated the service provider’s services and that the service provider had knowledge that he or she would be so terminated.35

4. Good Reason

Often, severance arrangements provide that severance is payable upon an involuntary separation for service without “cause,” which will constitute an involuntary separation from service under 409A. It is also common for severance arrangements to provide for separation pay in connection with a service provider’s voluntary separation from service under certain circumstances, generally referred to as “good reason.” Under the final regulations, a voluntary separation from service for “good reason” may be treated as an involuntary separation from service for purposes of the separation pay plan exception (as well as for purposes of analyzing the application of the short-term deferral exception as discussed in Chapter 6 (Short-Term Deferrals)), where the separation occurs as a result of one or more bona fide conditions that are pre-specified in the arrangement,

32 Id. 33 Id. 34 Id. 35 Id.

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assuming the purpose of permitting payment on the satisfaction of such conditions is not to avoid the application of 409A.36

a. General Requirements

The final regulations provide general guidance on what conditions may constitute satisfactory good reason to separate from service such that the separation from service on account of such conditions constitutes an involuntary separation from service.37 The general rule is that these conditions must result in a “material negative change to the service provider in the service relationship.”38 Examples of such material negative changes include changes in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received for performing such services.39 In addition, the final regulations indicate that other factors supporting a determination that a separation from service for good reason constitutes an involuntary separation are (1) that the amounts payable upon a separation from service for good reason are in the same amount and same form as payments available upon an actual involuntary separation from service and (2) that the service provider is required to give the service recipient notice of the existence of the condition that would result in good reason for separation from service and a reasonable opportunity to remedy the condition.40 Under the final regulations, an involuntary separation from service may also include termination by reason of the service recipient’s failure to renew a contract at the time a service provider’s contract expires, provided that the service provider was willing and able to execute a new contract providing terms and conditions substantially similar to those in the expiring contract and to continue providing those services.41

b. Safe Harbor

The proposed regulations did not provide any additional guidance regarding what specific provisions in a good reason definition would cause it to satisfy the general requirements described above. Largely in response to practitioner comments regarding the uncertainty this created, the final regulations included a specific “safe harbor” definition of good reason that can be relied on to ensure that a voluntary separation from service will be deemed an involuntary separation from service under 409A.42

To satisfy the safe harbor requirements, the definition of good reason must require the following:

First, the separation from service must occur during a predetermined limited period of time not to exceed two years following the initial existence of one or more of the following conditions arising without the consent of the service provider:43 36 Treas. Reg. §1.409A-1(n)(2). 37 Id. 38 Id. 39 Id. 40 Id. 41 Treas. Reg. §1.409A-1(n)(1). 42 See Treas. Reg. §1.409(a)-1(n)(2)(ii). 43 Treas. Reg. §1.409A-1(n)(2)(ii)(A).

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1. a material diminution in the service provider’s base compensation;44

2. a material diminution in the service provider’s authority, duties, or responsibilities;45

3. a material diminution in the authority, duties, or responsibilities of the supervisor to whom the service provider is required to report, including a requirement that the service provider report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation (or similar governing body with respect to an entity other than a corporation);46

4. a material diminution in the budget over which the service provider retains authority;47

5. a material change in the geographic location at which the service provider must perform the services;48 and

6. any other action or inaction that constitutes a material breach by the service recipient of the agreement under which the service provider provides services.49

Second, the amount, time, and form of payment upon the separation from service must be substantially identical to the amount, time, and form of payment payable due to an actual involuntary separation from service, to the extent such a right exists.50

Finally, the service provider must be required to provide notice to the service recipient of the existence of one or more of the conditions described above within a period not to exceed 90 days of the initial existence of the condition, and upon notice of which the service recipient must be provided a period of at least 30 days during which it may remedy the condition and not be required to pay the amount.51

The general rule and safe harbor provisions in the final regulations have given rise to significant discussion among practitioners analyzing specific separation pay plan provisions. The consequences of a “good reason” provision that fails to satisfy the general rule are significant. When the separation pay provided for under an agreement is not payable solely on account of an involuntary separation from service, the separation pay plan exception from 409A is unavailable (even if it is an involuntary termination that actually triggers severance payment). Likewise, as discussed in Chapter 6 (Short-Term Deferrals), depending on the extent to which the “good reason” definition fails to qualify

44 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(1). 45 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(2). 46 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(3). 47 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(4). 48 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(5). 49 Treas. Reg. §1.409A-1(n)(2)(ii)(A)(6). 50 Treas. Reg. §1.409A-1(n)(2)(ii)(B). 51 Treas. Reg. §1.409A-1(n)(2)(ii)(C).

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under the general rule, it might not constitute a substantial risk of forfeiture or might otherwise make the short-term deferral exception unavailable.

A draftsperson seeking certainty with respect to the availability of the separation pay plan exception would seek to include a “good reason” definition that matches exactly the safe harbor definition provided in the final regulations. Moreover, some argue, incorrectly in the opinion of the author, that the failure of a “good reason” definition to satisfy the safe harbor in every respect will cause it to fail to qualify for purposes of the separation pay plan exception. If the foregoing were the case, then it would seem that the inclusion of a general rule in the final regulations would not have been necessary. Instead, the inclusion of the general rule is ample support that there may be many circumstances in which a “good reason” definition may not match, in whole or in part, the language or substance of the safe harbor and yet still qualify for the exception under the general rule’s standard.

In circumstances in which the general rule is relied on for purposes of the exception, it is important to analyze each of the conditions imposed under the “good reason” definition to ensure that they require a material negative change to the service provider in the service relationship. It should not, however, be viewed as necessary that every prong of a good reason definition make use of the term “material.” Materiality in this context will depend on the existing relationship between the service provider and the service recipient. For example, it not uncommon for a “good reason” provision for a senior executive officer of a company to make reference to a change in his or her title. For certain employees, the mere change in his or her title may not give rise, by itself, to a material negative change to him or her. But for the most senior executives in a company, having the title of “chief executive officer,” “general counsel,” “chief financial officer,” or a similar title is often very significant, by itself, to the substance of his or her relationship with the service recipient. In that circumstance, it may be appropriate to conclude that any change to the service provider’s title, by itself, constitutes a material negative change to his or her relationship with the service recipient.

Similarly, in evaluating a “good reason” provision under the general rule, it is important to read the provisions in the context of “real world” business dealings rather than focusing on theoretical possibilities. For example, a “good reason” provision may include a condition that any decrease in base compensation gives rise to “good reason.” On its face, such a provision would appear to be problematic insofar as it could result in a service provider separating from service for “good reason” on account of only an immaterial reduction in base compensation (for example, a reduction of a single dollar). As a result, some could argue that the provision fails to satisfy the general rule’s requirement that the condition entail a material negative change.

However, because a scenario of an immaterial reduction in salary is exceedingly unlikely in the real world, it is not at all clear that the provision fails to satisfy the general rule. If, in addition, the “good reason” provision includes a requirement that the service provider give notice of his or her intent to terminate service because of such a reduction and that the service recipient have an adequate opportunity to remedy the condition, then depending on the facts and circumstances, it would appear reasonable to conclude that

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any employer acting rationally would always remedy any immaterial reduction in base compensation, as opposed to permitting the service provider to claim the right to separation pay (presumably in a far greater amount) on account of the satisfaction of an immaterial condition. This type of a provision, taken as a whole, would appear to require a material negative change in the service provider’s relationship before he or she becomes eligible for separation pay and would thus constitute a qualifying “good reason” under the general rule.

The analysis should be the same with respect to reductions in incentive compensation opportunities. In this regard, it is unfortunate that the safe harbor definition in the final regulations refers to only a material reduction in base salary. However, for the same reasons that apply in the analysis of a “good reason” definition that addresses reductions in base salary, a provision tying “good reason” to a reduction in incentive compensation that is materially adverse to the service provider should constitute a qualifying “good reason” under the general rule. Representatives of the Internal Revenue Service and the Treasury Department have informally confirmed this view in discussions with practitioners. Likewise, the absence of a specific reference to a “material” reduction should not lead to a different result if the provision, when taken as a whole with the notice provisions under the definition, would appear to require a material negative change in the service provider’s relationship with the service recipient. Alternatively, if the incentive compensation opportunity is written into the contract, a reduction may qualify as a material breach of contract.

Similarly, it should not be necessary to specify in a particular good reason definition that all conditions must be materially adverse. For example, it is common to include a provision triggering good reason upon the relocation of an employee’s principal place of employment. Often, this condition is described as one with specific geographic parameters, e.g., a relocation of more than 50 miles or outside a specified geographic area. It should not be necessary in such situations to also specify that the relocation be a materially adverse one in addition to satisfying the geographic requirements, provided that there is an independent basis for concluding that a relocation beyond the geographic limits specified in the definition would in fact be substantially likely to constitute a material adverse change. The theoretical possibility (if not foreseen in the facts and circumstances prevailing when the arrangement was entered into) that the relocation in an unlikely set of circumstances (for example, relocation in the direction of the service provider’s residence) could in fact trigger “good reason” without a material adverse change to the service provider should be disregarded.

In sum, a reasonable “facts and circumstances” analysis should apply to determine whether a particular good reason definition qualifies as a definition requiring a material negative change to the service provider’s relationship. If the facts and circumstances of a “good reason” definition are reasonable when the provision and the agreement within which it resides are read holistically, practitioners should be able to disregard theoretical concerns regarding the absence of “magic” language under 409A. Specifically, concerns over language that may not match exactly the safe harbor definition in the final

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regulations should not lead to an automatic conclusion that the definition is not a qualifying definition under the general rule.52

5. Amount and Timing Limitations

Once it has been determined that the payment at issue is payable solely upon an involuntary separation from service, the analysis must shift to the amount of the separation pay that is exempt from 409A. Specifically, excluding any amounts provided under collectively bargained53 and foreign separation pay plans54 and reimbursement arrangements that are exempt from 409A under the special exemption that applies for reimbursements provided during a “limited period of time” following separation from service, as discussed in Chapter 16 (Reimbursement Arrangements), the separation pay or portion of separation pay exempt from 409A cannot exceed two times the lesser of the following:

a. the sum of the service provider’s annualized compensation based on the annual rate of pay for services provided to the service recipient for the service provider’s taxable year preceding the service provider’s taxable year in which the service provider separates from service (adjusted for any increase during that year that was expected to continue indefinitely if the service provider had not separated from service); or

b. the maximum amount that may be taken into account under a qualified plan pursuant to Code section 401(a)(17) for the year in which the service provider separates from service.55 (For 2010, the applicable limitation under section 401(a)(17) is $245,000.)

Any separation pay in excess of these limitations cannot be exempt from 409A under the separation pay plan exemption (although it may still be exempt from 409A under another applicable exception, such as the short-term deferral exception).

Unfortunately, the final regulations do not provide detailed guidance on the determination of a service provider’s “annualized compensation.” It is not clear from the final regulations, for example, whether “annualized compensation” is to be determined based solely on compensation recognized as income for the preceding taxable year (in which case it would exclude items such as Code section 401(k) and 125 plan deferrals, as well as amounts that may have been deferred under a traditional deferred compensation plan), or whether annualized compensation is to be determined without regard to such deferral amounts. By comparison, the final regulations under the “golden parachute” provisions of Code section 280G do contain detailed instructions for determining compensation for purposes of identifying individuals subject to the limitations under section 280G, and expressly provide that compensation for that purpose is determined without regard to deferrals under Code sections 125, 132(f)(4), 402(e)(3), and 52 See Treas. Reg. §1.409A-1(n)(1). 53 Treas. Reg. §1.409A-1(b)(9)(ii). 54 Treas. Reg. §1.409A-1(b)(9)(iv). 55 Treas. Reg. §1.409A-1(b)(9)(iii)(A)(2).

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402(h)(1)(B).56 Whether, and how, any equity-based or other long-term incentive awards are included is also unclear under the 409A final regulations.

Likewise, the final regulations do not include any additional explanation regarding what is meant by “annual rate of pay” for determining this limitation. Does “annual rate” of pay mean something different from “actual” pay for the preceding taxable year (adjusted for increases in pay rate during the year)? In particular, where a service provider’s compensation for the preceding taxable year comprised both base compensation and bonus payments, it is difficult to know (unless the bonus payments were guaranteed) how to reflect bonus eligibility in the service provider’s “annual rate of pay.” It would appear that a bonus paid with respect to the prior year under a bonus arrangement that is expected to continue without substantial modification should be included in the service provider’s annual rate of pay for the purpose of determining the separation pay plan exemption amount. However, some practitioners dispute this view.

The second requirement relates to timing. The only separation pay or portion of separation pay that is exempt from 409A under this exception is that which by its terms must be paid no later than the last day of the service provider’s second taxable year following the service provider’s taxable year in which the separation from service occurs.57 For example, if the employee is terminated on June 12, 2010, the amounts that may be exempt under the separation pay plan exception are only those that must by their terms be paid not later than December 31, 2012. Thus, the exempt payment period varies between two and three years depending on when in the year a termination occurs. As discussed below in Section III.C. when only a portion of the severance is payable within two years following the termination year, only that portion qualifies for the separation pay plan exception (although other exceptions may apply to the other portions of severance).58

Example 1. An employer enters into an arrangement with an employee pursuant to which the employee will become entitled to 12 months’ base salary upon her involuntary separation from service at any time. The separation pay amount will be payable in a lump sum. The employee separates from service in 2010. Her base salary for 2009 (the taxable year preceding her taxable year in which she separates from service) is $200,000. The entire payment amount is exempt from 409A under the separation pay plan exception (as well as the short-term deferral exception).

Example 2. The facts assumed are the same as in Example 1 above, except that the severance payment is $1 million and the employee’s annualized compensation is $200,000. Accordingly, $400,000 of the severance will be exempt from 409A under the separation pay plan exception (i.e., two times the employee’s annual rate of pay for the preceding taxable year). The remaining $600,000 will not qualify for the separation pay plan exception (but should be exempt from 409A under the short-term deferral exception).

56 Treas. Reg. §1.280G-1, Q&A 21. 57 Treas. Reg. §1.409A-1(b)(9)(iii)(B). 58 Treas. Reg. §1.409A-1(b)(9)(iii).

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Example 3. The facts assumed are the same as in Example 1 above, except that the severance payment is $1 million and the employee’s annualized compensation is $500,000. Accordingly, $490,000 (two times the Code section 401(a)(17) limit for 2010, the year in which the employee separates from service) will be exempt from 409A under the separation pay plan exception. The remaining $510,000 will not qualify for the separation pay plan exception (but should be exempt from 409A under the short-term deferral exception).

Example 4. An employer enters into an arrangement with an employee pursuant to which the employee will be entitled to two times her base salary upon an involuntary separation from service, payable in monthly installments over a two-year period beginning on her separation from service. At the time of her separation from service, the employee’s base salary for the taxable year preceding her taxable year in which she separates from service in 2010 is $200,000. The entire separation pay amount should be exempt from 409A under the separation pay plan exception because it satisfies both the amount and timing limitations of the exception.

Example 5. The facts assumed are the same as in Example 4 above, except that at the time of her separation from service, the employee’s base salary for the taxable year preceding her taxable year in which she separates from service in 2010 is $500,000. Two times the section 401(a)(17) limit for 2010, or $490,000, of the payment amount is exempt from 409A. The remainder of the payment amount, or $510,000, will not be exempt under the separation pay plan exemption, although some of that amount may be exempt under the short-term deferral exception, as discussed below.

Example 6. The facts assumed are the same as in Example 5 above, except that the payment amounts will be paid in annual installments of $200,000 each over five years beginning on the employee’s separation from service. The employee separates from service on June 1, 2010. The first $490,000 of the installment payments is exempt from 409A because that amount satisfies both the amount and timing limitations of the separation pay plan exception (because all of the $490,000 is by its terms payable on or before December 31, 2012). The remainder of the payment amount, or $510,000, will not be exempt under the separation pay plan exemption.

Example 7. The facts assumed are the same as in Example 6 above, except that the payments are to be made in $250,000 installments on each of the second, third, fourth, and fifth anniversaries of the employee’s separation from service (that is, on June 1 of 2012, 2013, 2014, and 2015). Only the $250,000 payment made on June 1, 2012, is exempt from 409A because only that amount satisfies both the amount and timing limitations under 409A (because only $250,000 is by its terms payable on or before December 31, 2012).

6. Fungibility of Separation Pay

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As illustrated above, in some circumstances the separation pay plan exemption applies to only a portion of severance that is paid during the relevant period (because the amount limitation applies). Often the parties wish to avail themselves of the 409A exception to avoid the imposition of the six-month delay rule and, thus, apply the exception to the amounts first paid (so that the six-month delay would not apply to delay payment of these amounts). The parties may be less concerned about whether later paid amounts are subject to 409A where those amounts are in any event payable after the six-month delay period. However, there is no guidance on which portion of severance is considered exempt and no apparent requirement to apply the exception to the amounts first paid, which appears to provide some flexibility.

Example. A severance plan provides for payment of $800,000 payable over a period of 24 months following termination of employment. Because the plan does not specify that installment payments will be treated as separate payments, the short-term deferral exception is not available for any portion of the severance. The employee’s annualized compensation is $200,000, and his employment is terminated on December 31, 2010. Of the severance, $400,000 (two times the employee’s annualized compensation) is exempt under 409A. If the employee is subject to the six-month delay requirement, the parties probably want to view the $400,000 payable in 2011 as exempt because this would avoid having to apply the six-month delay to any of the employee’s payments. Suppose, however, the employee is not subject to the six-month delay or is indifferent to it. Rather, he would like to accelerate the payment of $400,000 payable in 2012 to be paid immediately (with the result that all of his severance will be paid in 2011). Subject to any applicable constructive receipt principles, the $400,000 payable in 2010 is exempt; therefore, no prohibition of acceleration applies to it..

B. Window Programs

Any portion of separation pay that is payable under a program that satisfies the requirements of a window program, as discussed above in Section II.C. will be exempt under 409A to the extent it satisfies the amount and timing limitations applicable to the separation pay plan exception59 discussed above. in Section III.A. Specifically, amounts are exempt from 409A to the extent they are paid under a window program, do not exceed the “two times” requirement as described above in Section III.A.5. and must be paid within the two-year period following the year of termination60 described above in Section III.A.5. To the extent that a portion of the payments under a window program do not satisfy those limitations, they may be subject to 409A, depending on their terms, and the payments must be analyzed for purposes of 409A’s form and timing of payment rules, including the satisfaction of the potential six-month delay discussed in Chapter 10 (Permissible Payments) as deferred compensation payments payable upon separation from service.

It is important to note, however, that the discussion above regarding involuntary separation from service and “good reason” is not relevant to the analysis of payments 59 Treas. Reg. §1.409A-1(b)(9)(iii). 60 Id.

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under a window program. As indicated above, separation pay satisfying the amount and timing limitations described above will be exempt from 409A if paid under a window program, regardless of whether the separation from service triggering the payments is voluntary or involuntary.61

C. Stacking

An important consideration in analyzing separation pay arrangements is that the exceptions from 409A are additive—that is, it is acceptable to “stack” exceptions. The final regulations and their preamble indicate that the separation pay plan exception (including the collectively bargained and foreign separation pay plan exceptions and the special limited time reimbursement exception) may be used in combination with other exceptions, including the short-term deferral exception.62 Therefore, a portion of a service provider’s severance may be exempt from 409A under the short-term deferral rule, a portion may be exempt under the separation pay plan exception, and any remainder would constitute deferred compensation subject to 409A.63 Appendix ___ illustrates, in the form of a flowchart, how these exceptions interact.

However, care must be taken to ensure that stacking is available, because the conditions for availability of the exemptions differ. For example, assume a separation pay plan that provides for separation pay payable in a stream of installments, which, in the aggregate, exceed the amount limitation discussed above in Section III.A.5. It may be possible to exempt from 409A a portion of the separation pay under the separation pay plan exception (specifically that portion that satisfies the amount restriction) and, separately, the remainder under the short-term deferral exception, such that all of the payments, when taken together, are exempt from 409A. However, for the short-term deferral exception to be available for a portion of the separation pay, the installment payments need to be designated as separate payments as contemplated by the final regulations and as discussed in Chapters 6 (Short-Term Deferrals) and 9 (Changes in Time and Form of Payment). If designated as separate payments, each payment could be considered separately and measured against both the separation pay plan and the short-term deferral exceptions. The payments paid earliest in the stream may then be more easily exempted under the short-term deferral exception, and, after subtracting those payments from the whole for purposes of a 409A analysis, the remaining payments may fall within the amount limitations of the separation pay plan exemption, as illustrated in the flowchart in Appendix __.

If a series of installment payments is not designated as a series of separate payments, then although the separation pay plan exception would continue to apply up to its applicable amount and timing limitations, the short-term deferral exception would not be available unless all installment payments were to be made within the applicable short-term deferral period.64 For this reason, many practitioners believe it is always desirable, 61 See id. 62 See Treas. Reg. §1.409A-1(b)(9); see also Preamble §III(J)(1) (second paragraph), 72 Fed. Reg. 19,234, 19,246. 63 See Treas. Reg. §1.409A-1(b)(9)(i). 64 Treas. Reg. §1.409A-2(b)(4).

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particularly in the context of separation pay plans, to designate each installment payment as a separate payment as a prophylactic matter (although even if redeferrals of separation pay amounts in the typical separation pay arrangement are not common, care must still be taken to understand the implications for making the election for purposes of redeferrals of amounts that constitute deferred compensation subject to 409A, as discussed in Chapter 9 (Changes in Time and Form of Payment).

Please see Appendix ___ for a detailed flowchart describing how “stacking” may be used in connection with separation pay arrangements to exempt all or certain portions of applicable payments from 409A.

Example. An employee is party to a severance agreement that provides that, upon her involuntary termination of employment without cause, she will receive aggregate severance payments equal to three times her base salary, which as of the date of her termination is $400,000. The employee separates from service without cause on April 1, 2010. The severance payments are payable in three installments, with the first installment payable upon separation from service and the remaining two installments payable on the first and second anniversaries of her separation from service. The severance agreement provides that installment payments are to be treated as separate payments. The aggregate severance amount of $1,200,000 would exceed the separation pay plan exemption limits even though payable within two years from the employee’s separation from service. However, the first installment payment of $400,000 will be exempt from 409A as a short-term deferral. The entire second installment payment of $400,000 will be exempt from 409A under the separation pay plan exemption because it is below the limit on the amount of payment and is payable within two years from separation from service. Of the third installment payment, $90,000 will be exempt from 409A because it is still within the amount and timing limitations of the separation pay plan exemption. The remainder of the third installment payment ($310,000) will be subject to 409A, because it exceeds the amount limitations under the separation pay plan exemption, but it will qualify as a compliant payment under 409A because it is paid on a fixed payment date (See Chapter 10 (Permissible Payments)).

D. Substitutions

One important factor to consider in structuring a severance arrangement where there is also a preexisting right to deferred compensation under an arrangement subject to 409A is the prohibition of the “substitution” of amounts that are deferred compensation for amounts that are not deferred compensation.65 This rule, discussed in more detail in Chapter 11 (Acceleration of Payments), effectively prohibits offset-type arrangements where the amount payable as deferred compensation is offset by a variable amount payable under one of the exceptions, including the separation pay plan exception.66

65 See Treas. Reg. §1.409A-3(f). 66 See id.

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For example, assume that an individual is a party to an employment agreement providing for a discretionary amount of between $100,000 and $200,000 payable in a lump sum promptly upon an involuntary separation from service. This payment qualifies for the separation pay plan exception (or, alternatively, the short-term deferral exception). The same individual is also entitled to payments of deferred compensation under a deferred compensation plan subject to 409A. The deferred compensation payments are to be made in fixed monthly payments over a period of three years after a separation from service. If either arrangement provides that the amount of deferred compensation payable would be offset by the discretionary amount paid under the employment agreement (excluded from 409A under the separation pay plan exception), that would be problematic. In that case, the exercise of discretion to increase the separation pay plan amount would have the effect of substituting something that is not deferred compensation for something that is deferred compensation, which, under 409A, would be an impermissible acceleration of the scheduled deferred compensation payments.

The final regulations provide more detail on what factors must be considered in determining whether an impermissible substitution of payments exempt from 409A has been made for amounts subject to 409A. For example, the final regulations indicate that if a service provider has a legally binding right to an amount of deferred compensation payable on a future date that would be forfeited upon separation from service and if the service provider forfeits this payment but receives a purportedly unrelated separation payment at separation from service pursuant to a new arrangement, the payment pursuant to the new arrangement may be viewed as a substitute for the purportedly forfeited deferred compensation.67 The conclusion depends on the facts and circumstances of the arrangement.68 However, if the separation from service is voluntary, the final regulations indicate the payment is presumed to be a payment of the purportedly forfeited deferred compensation, which is likely to violate the prohibition of acceleration under 409A.69

This presumption may be rebutted by demonstrating that the service provider would have obtained the right to the payment under the new arrangement regardless of the forfeiture of the nonvested right.70 In addition, a factor that would support rebuttal of the presumption is that the amount to which the service provider obtains a right under the new arrangement is materially less than an amount equal to the present value of the amount forfeited under the deferred compensation arrangement multiplied by a fraction, the numerator of which is the period of service the service provider actually completed, and the denominator of which is the full period of service the service provider would have been required to complete to receive the full amount of the payment.71 For example, where a service provider is entitled to a future payment only if the service provider completes three years of service and at the time of separation from service the service provider has completed one year of service, the presumption could be rebutted if the payment to the service provider is materially less than the present value of one-third of the nonvested amount. The regulations provide no guidance on what “materially less” 67 Treas. Reg. §1.409A-1(b)(9)(i). 68 Id. 69 Id. 70 Id. 71 See id.

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means in this context. Another factor included in the final regulations is that the payment to the service provider is of a type customarily made to service providers who separate from service with the service recipient and do not forfeit nonvested rights to deferred compensation (for example, a payment of accrued but unused leave or a payment for a release of actual or potential claims).72 Chapter 11 (Acceleration of Payments) discusses the substitution rules of 409A in detail.

IV. SPECIAL RULES AND EXCEPTIONS

In addition to the separation pay plan and window program exceptions discussed above in Section III. there are several other exceptions that may be of more limited applicability but nonetheless very helpful, when applicable. Specifically, the final regulations provide exceptions for separation pay plans that are the subject of collective bargaining without regard to the amount and timing limitations described above.73 In addition, certain foreign separation pay plans and de minimis separation pay payments are excepted from 409A.74

A. Collectively Bargained Separation Pay Plan Exception

A separation pay plan is not subject to 409A to the extent the plan is a collectively bargained separation pay plan that provides for separation pay only upon an involuntary separation from service or pursuant to a window program.75 Only the portion of the separation pay plan attributable to employees covered by a bona fide collective bargaining agreement is considered to be provided under a collectively bargained separation pay plan.76 “A collectively bargained separation pay plan is a separation pay plan that meets the following conditions:”

(A) The separation pay plan is contained within an agreement that the Secretary of Labor determines to be a collective bargaining agreement.

(B) The separation pay provided by the collective bargaining agreement was the subject of arm’s length negotiations between employee representatives and one or more employers, and the agreement between employee representatives and one or more employers satisfies [Code] section 7701(a)(46).

(C) The circumstances surrounding the agreement evidence good faith bargaining between adverse parties over the separation pay to be provided under the agreement.77

72 See id. 73 See Treas. Reg. §1.409A-1(b)(9)(ii). 74 See Treas. Reg. §1.409A-1(b)(9)(iv), (v). 75 Treas. Reg. §1.409A-1(b)(9)(ii). 76 Id. 77 Treas. Reg. §1.409A-1(b)(9)(ii)(A)–(C).

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See also the discussion in Chapter 22 (Collectively Bargained Plans). It is important to note as well that certain terms, such as “separation from service” and “involuntary separation from service,” have differing definitions for purposes of the collectively bargained plan exception, as discussed in Chapter 22 (Collectively Bargained Plans).

B. Foreign Separation Pay Plan Exception

A separation pay plan (including a plan providing payments upon a voluntary separation from service) is not subject to 409A to the extent the plan provides for amounts of separation pay required to be provided under the applicable law of a foreign jurisdiction.78 For this purpose, a provision of foreign law is considered applicable only to foreign earned income (as defined under Code section 911(b)(1) without regard to section 911(b)(1)(B)(iv) and without regard to the requirement that the income be attributable to services performed during the period described in section 911(d)(1)(A) or (B)) from sources within the foreign country that promulgated such law.79 See also Chapter 21 (Foreign Plans) for a more detailed discussion of the exception from 409A for foreign plans generally and its application to foreign separation pay plans.

C. Limited Separation Payment Exception

A taxpayer may treat a right or rights, if not otherwise excluded, under a separation pay plan to a payment or payments as not being subject to 409A to the extent such payments in the aggregate do not exceed the applicable dollar amount under Code section 402(g)(1)(B) for the year of the separation from service, regardless of whether the separation from service is voluntary or involuntary.80 (For 2010, the limit is $16,500.) This amount may be “stacked” with other exceptions, for example , with the separation pay plan exception, and exceptions for certain reimbursement arrangements discussed in Chapter 16 (Reimbursement Arrangements).

78 Treas. Reg. §1.409A-1(b)(9)(iv). 79 Id. 80 See Treas. Reg. §1.409A-1(b)(9)(v)(D).