When a company negotiates either an employment agreement or separation agreement with an employee, the employee benefits offered are typically a large piece of the total package. However, the terms of these types of agreements are subject to various federal and state laws that can be difficult to navigate and coordinate. Examples include Section 409A of the Internal Revenue Code (the “Code”) and continuation health coverage under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). As such, careful drafting is required by employers in order to prevent adverse tax consequences to all parties.  Below are 10 employee benefits and compensation issues that should not be overlooked by employers when drafting employment and separation agreements.

1. Salary Continuation and Code Section 409A

Oftentimes, separation agreements will provide for severance payments in the form of salary continuation for a period of time following the employee’s termination date. Generally, a payment made in a later taxable year than the taxable year in which the employee has a legally binding right to it is considered “deferred compensation.”  Deferred compensation is subject to Code Section 409A. However, depending on the payment structure, severance payments may be exempt from Section 409A as “separation pay.” The separation pay exemption applies if:

• Severance is payable upon an involuntary separation from service,
• The amount does not exceed two times (2x) the lesser of the employee’s annualized compensation for the year prior to the year of termination or the Code Section 401(a)(17) limit ($280,000 for 2019) for the year of termination, and
• Severance is required to be paid no later than the last day of the second taxable year following the year of the employee’s termination.

Failure to comply with Code Section 409A results in immediate taxation on the full amount of the deferred compensation to the employee, an additional twenty percent (20%) penalty tax, plus a separate premium interest tax. Employers will also be impacted by a Section 409A violation because of the failure to report and withhold taxes on the severance payment for the correct taxable year. However, even if the desired severance pay structure does not meet the separation pay exemption, there are other exemptions under Section 409A that can be considered as well, even if the desired severance payment structure does not comply with the separation pay exemption. Employers should work with benefits counsel to carefully draft agreements involving deferred compensation.

2. Release Timing and Code Section 409A

A separation agreement can also violate Code Section 409A if timing of the severance payment is wholly dependent upon the timing of the employee’s execution of the agreement. This includes release consideration and revocation periods that flow from the timing of the employee signing the agreement. Code Section 409A prohibits employees from electing the timing of payment, which could potentially change the taxable year in which the severance is received. While this can be problematic in all instances where the severance payment is dependent upon the timing of the employee’s execution of the agreement, it is even more problematic for separation agreements that are offered at the end of the calendar year when any delay in execution could impact the taxable year in which the severance payment is received by the employee.  

Similar issues may arise if severance negotiations extend into a different taxable year. For example, a severance agreement is offered to a CEO on December 15, 2019 and provides a 45-day consideration period with payment 10 days after the CEO’s execution of the agreement. Here, the CEO could sign the agreement immediately and receive payment in 2019 or wait until the end of the consideration period to sign and receive payment in 2020. Choosing a date certain to provide payment that is not contingent upon the timing of the employee’s signature can minimize potential Code Section 409A issues. Therefore, a possible solution in the example provided would be drafting the agreement so payments will be made 60 days after the CEO’s termination date, if the agreement is signed and not revoked.

3.  Changes to Employment Agreements and Code Section 409A

Once the employee and the employer enter into an employment agreement specifying a time and form of deferred compensation that is compliant with Code Section 409A, any subsequent changes to the time and form of payment must comply with special rules concerning changes in payment under Code Section 409A.  These rules provide that:

• The election to change the payment may not take effect until at least 12 months after the date the election was made.
• The new payment date is at least 5 years later than the date the payment otherwise would have been made.
• The election must be made at least 12 months before the date the payment otherwise would have been made (for payments that were originally scheduled to be paid on a specific payment date or fixed schedule).

For example, a CEO is entitled to a $100,000 retention bonus to be paid to him on June 1, 2020 if he is still employed on December 31, 2019. If the company and the CEO want to amend the agreement in 2019 to pay him the retention bonus one year later than originally scheduled, on June 1, 2021, this would violate Code Section 409A. Any amendment delaying the payment date is required to be effective before June 1, 2019 and the payment cannot be made to CEO until June 1, 2025. Again, these provisions were added to the Code in order to dissuade executives from choosing, and Companies from changing, which taxable year they will receive deferred compensation.

4. Compensation & Constructive Receipt Issues

Employment agreements also have the potential to create adverse tax consequences under Code Section 83 and the constructive receipt doctrine. Generally, a taxpayer who has an unrestricted right to receive income is deemed to have constructive receipt of income even though the employee has not actually accepted the income. For example, if a sales person earns a $100,000 commission on June 1, 2019, he is deemed to receive the income in 2019 even if he tells his employer not to pay him the commission until June 2020.  

5. Taxability of Non-Cash Benefits

While non-cash benefits can enhance the value of an employment agreement, employers should be aware of whether the fair market value of these benefits is taxable as income to the employee. Generally, gross income means all income from whatever source derived. Therefore, in order for a non-cash benefit to be excluded from an employee’s income, there must be an explicit tax provision providing for exclusion. For example, reimbursement for the cost of moving expenses for a newly hired employee was previously nontaxable as a qualified moving expense reimbursement fringe benefit under Code Section 132. The recent Tax Cuts and Jobs Act suspended this specific fringe benefit for tax years 2018 to 2025. Therefore, any payment for moving expenses must now be considered income to the employee, even though up until recently it was not.

6. Drafting COBRA Language

When drafting separation agreements, employers typically include a paragraph addressing COBRA benefits. However, COBRA benefits are only available to employees who elected health coverage through the employer during employment. Therefore, any reference to COBRA benefits should be removed or omitted when a severance package is offered to an employee who does not participate in the employer’s group health plan. In addition, if an employer would like to subsidize COBRA benefits for the severed employee, the employer should be specific as to whether it is subsidizing for only the employer portion of the premium or both the employee and employer premium amounts. Lastly, the separation agreement should clearly address whether the COBRA subsidy will be paid in the form of a reimbursement after the premium is paid by the severed employee or the employer will continue to pay the premiums directly.

7. Paying for COBRA Coverage

If a company has a practice or policy of paying for all or a portion of employees’ COBRA payments upon separation from employment, it should be cognizant of the makeup of the workforce it is providing such benefits to. For example, payments of COBRA premiums are generally not taxable under Code Section 105. However, Code Section 105(h) requires that health benefits provided to employees under self-insured medical plans do not discriminate in favor of “highly compensated individuals.” The term “highly compensated individuals” is defined in the statute as an individual who is:

• One of the top 5 highest paid officers;
• A shareholder who owns more than 10 percent in the value of the stock of the employer; or
• Among the highest paid 25% of all employees.

For example, a company with a self-insured medical plan that only pays COBRA premiums to its C-suite executives, and not rank and file employees, is likely to violate the nondiscrimination requirement of Code 105(h). Failure to comply with Code Section 105(h) results in these highly compensated individuals being taxed on the medical premiums paid for them by the company.

8. Employment Through Bonus Payment Date

Some employers offer discretionary bonus payments annually to their employees. Generally, bonus payments are made in the first quarter of the calendar year following the performance year in which the employee was evaluated for bonus eligibility. Employers will sometimes require employment through the payment date in order to receive a bonus. Therefore, employees terminated from employment before the bonus payment date will not receive a bonus. State laws differ on whether a bonus has been “earned” so as to constitute wages that must be paid to a terminated employee.  

In Maryland, for example, employee bonus policies that expressly condition the payment of bonuses on an arbitrary requirement, such as continued employment, can be challenged. This may result in a bonus payout to an employee who terminates early. Moreover, the manner in which the bonus program is communicated to employees can alter the analysis of whether a bonus is considered earned. This includes whether handbooks or offer letters contain discretionary or entitlement language when describing bonus policies. Careful drafting is needed when describing bonus payments in employment agreements or offer letters to minimize ambiguity. Similarly, when an employee is terminated, employers should determine whether a bonus is required to be paid out when processing the final paycheck or when valuing a severance package as a whole.     

9. 401(k) Deferrals and Severance Pay

Many employers continue to process an employee’s severance pay through their payroll administrator or department, especially if the severance is paid in the form of salary continuation. While employment tax and social security withholdings remain the same for employed or terminated employees, salary deferrals into an employee’s 401(k) plan cannot be continued as severance pay because severance pay does not meet the definition of “compensation” under Code Section 415. This is a common mistake, especially when payments are not coded or processed as severance pay in a company’s payroll system. This type of mistake, if made, must be fixed in order to keep the tax qualified status of the company 401(k) plan. The fix may involve filing the correction with the IRS. Another common mistake that can cause qualification issues with a company’s 401(k) plan is when a terminated employee continues to be paid through payroll for a period of time after termination, also referred to as “garden leave.” This is because the IRS does not utilize an employee’s designated termination date for 401(k) purposes, but rather the employee’s “separation from service.” If the employee is not performing services for the company, whether or not still on the payroll, the garden leave payments may still be considered severance pay and not compensation under 401(k) plan contribution and distribution rules.

10. Equity Awards

Equity awards are often included in employment and separation agreements as part of an employee’s compensation package. Equity awards are governed under the terms of a separate equity plan and cannot be changed by the terms of a separation or employment agreement. For example, if an employee is vested in company stock, he is entitled to the stock even if the company terminates him and provides in his separation agreement he will be receiving cash in lieu of company stock.  

In sum, there are many taxation and benefits issues that can arise with employment and separation agreements that should not be overlooked by employers. Careful drafting is needed to avoid adverse tax consequences for employees and employers.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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