Most employers are aware that Section 409A of the Internal Revenue Code requires all forms of nonqualified deferred compensation plans to be amended and restated prior to Dec. 31, 2008.

Severance plans were included in the arrangements requiring consideration under Section 409A, since they provide for post-employment payments that can be paid beyond two-and-a-half months after the end of the calendar year in which an employee leaves.

Due to the complexity under Section 409A, correction programs were first announced in IRS Notice 2008-113. The IRS also created a document correction program under Notice 2010-6, as recently extended in part and modified by Notice 2010-80.

Severance plans and employment agreement containing severance benefits are unique documents in that they generally provide for both the payment of post-employment compensation, as well as the continuation of medical coverage for a period of time.

As a result of the provision of medical coverage, severance plans now are required to be re-examined due to the extension of Section 105(h) of the Code under the Patient Protection and Affordable Care Act to fully insured medical plans effective for plan years beginning on or after Sept. 23, 2010.

For most employers maintaining calendar-year severance pay programs, the new rules apply as of Jan. 1, prior to the issuance of recent guidance. In essence, the new rules provide that fully insured health plans may not discriminate in favor of highly compensated employees.

It is imperative to review employment agreements, offer letters and individual severance agreements to ensure compliance with both the Sections 409A and 105(h). I’ll address two common situations involving severance plans and the alternatives available to employers.

Example 1

Assume an employer maintains a fully-insured health plan. The employer also maintains a severance plan for all employees who have been with the employer for at least one year.

Under the severance plan, employees receive a benefit equal to two weeks of pay for each year of service up to a maximum benefit of six months. Both highly and non-highly compensated employees receive the same severance benefit.

The employer previously has reviewed the severance plan for compliance with Section 409A and has established fixed payments dates for purposes of either lump-sum benefits and/or payments made in accordance with regular payroll cycles until all benefits are paid.

Further, the employer provides a COBRA subsidy for health benefits for the full period in which severance benefits are being paid, or would be paid if not paid in a single lump-sum payment.

In general, the above plan will satisfy the new Section 105(h) rules applicable to health care coverage, since the employer subsidy for COBRA coverage is provided uniformly to all employees based upon years of service, and does not discriminate in favor of highly compensated employees.

Although the employer has satisfied the new Section 105(h) rules as applied to fully insured health plans for the severance plan, an important issue to reconsider under Section 409A is the execution of releases by employees.

For example, assume the employer provides for a single lump-sum payment for the full amount of severance benefits and that an employee’s termination occurred on Dec. 10, 2010, in connection with a single job elimination.

Under the Older Workers Benefits Protection Act, the severance plan provides for a 21-day review period for individual terminations. The severance plan further provides that the lump sum payment is made within 10 days after execution of a release absolving the employer, its board of directors and all employees of any liability.

Based on these facts, the individual could immediately execute the release, and receive the severance benefit in 2010. Or, the individual could delay execution of the release and receive payment in 2011. In general, the IRS does not permit employees to have control over the tax year in which severance benefits will be paid.

To preclude employees from gaming when severance benefits are paid, the severance plan should provide that if the election period straddles two tax years, all severance benefits will be paid in the second calendar year, no later than March 15 of the second calendar year.

This establishes a rule under which a participant cannot control the timing of payment for the severance benefit, and also satisfies the general rule that benefits paid within two-and-a-half months after the end of the calendar year in which the employee leaves.

Even simple severance plans must be reconsidered in light of Section 409A. Any impermissible delays in payment under the above severance plan were originally required to be corrected by Dec. 31, 2010.

However, as a result of IRS Notice 2010-80, employers may now correct the above release language prior to Dec. 31, 2012. Release provisions can also comply with Notice 2010-80 by delaying payments to the second calendar year for payments made after March 31, 2011.

Example 2

Assume the employer maintains two separate severance plans. Severance plan No. 1 is the same as the severance plan identified above but is restricted to non-executive employees. Severance plan No. 2 provides a benefit equal to one year of severance benefit for all individuals designated as vice presidents and above.

The employer has considered Section 409A of the Code, and has already provided that releases that straddle two tax years will require payment in the second calendar year to satisfy Section 409A.

Under this example, the employer must still consider the extension of Section 105(h) to fully insured plans. The basic severance plan should continue to be permitted under PPACA, since it does not discriminate in favor of highly compensated employees.

However, benefits paid under the executive severance plan would appear to fail to satisfy PPACA. Thus, under these circumstances, providing a subsidy for COBRA coverage for a single executive for a one-year period could result in a violation of Section 105(h).

At this time, it’s generally believed that the penalty will be $100 per day, multiplied by the number of employees within the employer’s single-employer controlled group under Section 414 of the Code, who are not receiving the discriminatory benefit. Thus, for a company with 500 employees, the employer could face a penalty of approximately $50,000 per day.

The good news is employers and practitioners received an early holiday gift when the IRS issued Notice 2011-1 on Dec. 22, 2010. This notice provides that until guidance is issued the application of Section 105(h) to insured health plans will not be enforced.

The penalties of noncompliance with Section 409A are imposed on the employee, and not the employer. The penalties under Section 409A result in immediate income taxation for the employee, a 20% excise tax, and underpayment of interest penalties.

Conversely, the extension of health benefits in violation of Section 105(h) for a fully insured plan results in penalties to the employer. Employers must seriously consider both the Section 409A and the Section 105(h) rules in connection with any post-employment benefits, severance and medical benefits.

Employers should be further encouraged to review all employment agreements, offer letters and individual severance agreements providing for execution of releases and extension of health care coverage.

Most practitioners expected the IRS to issue guidance to provide relief for the new Section 105(h) rules due to the need to revise and renegotiate numerous agreements. Even though this guidance has been issued, employers should still identify and monitor agreements requiring future changes.

Palmieri can be reached at

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