Impact of New Deferred Compensation Tax Rules on Severance Pay Arrangements

The American Jobs Creation Act of 2004, enacted in late October, added new Section 409A to the Internal Revenue Code, which significantly changes the taxation of nonqualified deferred compensation plans. Section 409A imposes restrictions on deferral elections, distribution elections, distribution events and acceleration of payments. Failure to comply with Section 409A will lead to immediate taxation of deferrals, with interest and a 20% penalty. Section 409A is generally applicable to amounts deferred after December 31, 2004, and thus in the context of severance payments would appear to apply to severance amounts payable on or after January 1, 2005 (at least where the severance event did not occur prior to January 1, 2005). For additional details on the overall effect of new Section 409A, see New Federal Legislation Will Require Review of Deferred Compensation Plans.

“Nonqualified deferred compensation plan” is broadly defined to include any plan, agreement or arrangement (including one that covers only one person) that provides for the deferral of compensation, other than a qualified employer plan or a bona fide vacation, sick leave, compensatory time, disability pay or death benefit plan. Section 409A does not contain any specific exception for severance pay arrangements.

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