Senior-level employees often enter into contracts stating they will receive separation pay if their employment is terminated unexpectedly. For example, employers often promise executives severance pay unless they are fired “for cause.” Other times, a company will promise that an executive can resign and collect severance pay following a change in control of the company. 
If drafted the right way, employment agreements can create incentives for executives to accept challenging assignments and continue working during times of upheaval. If agreements are drafted the wrong way, however, the IRS can perceive them as providing “nonqualified deferred compensation,” which is subject to steep tax penalties and interest. Before entering into such agreements, employers should know what to look for so they can identify when it is necessary to consult a professional. (Hint: It is almost always advisable to do so!)
Section 409A of the Internal Revenue Code and its regulations present a minefield of potential tax consequences associated with nonqualified deferred compensation, which can be any payment made during a tax year after the year the payment was earned (unless part of a “qualifying” plan such as a 401(k)). Unless the payments are exempt from Section 409A through careful drafting (or blind luck), they can be taxed as soon as they vest, and they can be subject to an additional 20 percent excise tax. In other words, an employee earning nonqualified deferred compensation can be taxed before receiving payment at a marginal tax rate exceeding 75 percent!
Although many different kinds of employment contracts implicate Section 409A, some of the most common scenarios involve agreements for severance payments. Essentially, when a company promises to provide an employee compensation in the future, the payments will be subject to Section 409A unless the promise is carefully framed. This article briefly identifies some of the issues with employment agreements employers should be on the lookout for.
Step 1: Identify when payments will be made
Section 409A applies only to “deferred compensation,” so it comes into play only when an employee obtains a legally binding right to receive compensation in a later year. Accordingly, Section 409A does not apply when an employer makes a promise and provides an associated payment in the same year.
Likewise, Section 409A does not apply to payments made 2½ months following the end of the tax year in which the payments vested. For example, if an employee was terminated on January 1, 2015, and signs a severance agreement on the way out the door, payments received before March 15, 2016, will not be subject to penalties. The challenge, however, is identifying exactly when a promise of compensation vests. It is not as simple as it sounds.
Step 2: Identify what the right to payment depends on
Even if an employee’s right to receive compensation is contingent upon something happening first, the promise to pay might still be subject to immediate Section 409A tax treatment. For example, an employment agreement stating that an employee’s right to receive severance pay is dependent on him leaving the company is not enough. Generally, Section 409A exempts “separation from service” payments only if they are associated with an involuntary separation. Otherwise, an employee could quit and accelerate his right to collect severance pay.
It is possible for a company to promise severance pay if an employee quits, but for the payments to be exempt from Section 409A, the resignation—for all intents and purposes—still must be involuntary. Section 409A’s regulations set forth limited circumstances in which an employee can quit for “good reason” and collect severance pay without incurring a tax penalty. For example, an executive who experiences a material diminution in her authority might have good reason to quit. An executive who suffers a cut in his base compensation might have good reason to quit. However, if an agreement specifies grounds on which an employee can quit for good reason and the grounds do not fall within Section 409A’s limited “safe harbor” provisions, the severance payments can still be subject to penalties.
Also, an agreement can allow an employee to quit and collect severance pay following a “change in control” of the company. But as with “good reason” provisions, “change in control” clauses must be narrowly defined to fit within Section 409A’s regulations. It is essential to consult a professional if you are considering including such language in an employment agreement.
Furthermore, making severance pay contingent upon an employee signing a release of claims or a noncompete agreement will not automatically exempt the payments from Section 409A. An agreement will not avoid tax penalties unless it sets a short deadline for the employee to sign the release or covenant.
Step 3: Ensure severance payments fall within cap
Employment agreements containing the right “good reason” or “change in control” language might still expose severance payments to Section 409A treatment unless the payments are capped. Under Section 409A’s “2×2” rule, severance payments are generally limited to “two times the lesser of” (1) the sum of the employee’s annualized compensation over the preceding year or (2) Section 401(a)(17)’s limit for the year the separation occurs.
The 401(a)(17) limit for 2015 is $265,000, effectively setting the 2015 cap for severance payments at $530,000. Payments over that amount will be subject to Section 409A penalties and interest. Generally, Section 409A treats an entitlement to a series of installment payments as a right to a single payment, so providing for severance pay to be meted out over time may not be enough to avoid unnecessary tax liability.
Step 4: Determine whether payments must be delayed
Section 409A places additional requirements on publicly traded companies. For “specified employees,” which generally include a company’s 50 most highly compensated officers, employers cannot pay severance benefits until six months after termination. A company can cut the period short only if a specified employee dies before the six months expire.
Bottom line
Although most employees do not sign employment agreements—let alone agreements that provide for generous severance pay—Section 409A has significant tax implications for employees who do. Typically, employers offer such agreements to incentivize key executives, but Section 409A can make the agreements punitive. It is easy for employers to unwittingly subject employees to high taxes and penalties.
To be safe, employers should contact legal counsel whenever they are contemplating entering into an agreement that could be construed to offer deferred compensation. Competent counsel—preferably with 
tax expertise—can help employers navigate the hundreds of pages of applicable regulations and draft agreements to help them accomplish their goals of incentivizing and rewarding key employees.
Matthew H. Parker is an attorney at Whelan, Corrente, Flanders, Kinder & Siket LLP in Providence, Rhode Island, specializing in labor and employment law and business litigation. He may be contacted at mparker@whelancorrente.com.