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“Good Reason” to Read Final 409A Regulations

The final Section 409A regulations address a concern raised by many employers and their advisors after reading the proposed regulations: the uncertainty concerning the effect of provisions in employment agreements, severance plans, and the like entitling an executive to receive deferred compensation on a voluntary resignation for “good reason.”  Under the final regulations, a document incorporating such a “good reason” provision is far more likely to qualify for an exception to the Section 409A rules than it was under the proposed regulations.

The proposed regulations reflected the IRS’ view that good reason clauses are generally a subterfuge — designed to give executives a guaranteed source of deferred compensation — and are therefore inconsistent with the constraints imposed by Section 409A.  As explained in this article, the final regulations adopt a far more realistic approach to “good reason” resignations.  Nonetheless, employers, executives and their advisors will want to examine any such provisions to make sure they qualify for the relief offered by the final regulations

BACKGROUND UNDER PROPOSED REGULATIONS

The concept of a “good reason” resignation is important under two different regulatory exceptions to the application of Section 409A.  These are exceptions for “short-term deferrals” and for certain “involuntary severance programs.”

Short-Term Deferral Exception.  The exception to Section 409A for short-term deferrals applies if deferred amounts are paid out (or otherwise includible in an executive’s taxable income) within 2½ months after the close of the year (either the calendar year or the employer’s taxable year) in which those amounts are no longer subject to a “substantial risk of forfeiture” (i.e., when they become vested).  In general, amounts are subject to a substantial risk of forfeiture if an executive must continue to provide services to the employer in order to receive them.

Even the proposed regulations conceded, however, that a provision vesting an executive on an involuntary separation from service does not undermine a substantial risk of forfeiture.  Thus, the short-term deferral exception could still apply if amounts were paid out within 2½ months after the close of the year in which an executive suffered an involuntary separation from service.

The proposed regulations were far less generous, however, as to provisions allowing an executive to receive deferred compensation following a voluntary resignation for good reason.  Those regulations warned that such a provision might not create a substantial risk of forfeiture. Because this would require that the executive be treated as immediately vested in all deferred amounts, the short-term deferral exception would rarely apply.

Involuntary Severance Exception.  Both the proposed and final regulations contain an exception to Section 409A for “separation pay plans” that provide for payment upon “involuntary separation from service.”  This exception is both broader and narrower than the short-term deferral exception.  On the one hand, this severance pay exception allows payments to be made through the end of the second calendar year after the calendar year in which an executive’s separation from service occurs.  On the other hand, there is a cap on the amount of severance pay that may fall within this exception.

The proposed regulations did not include a voluntary resignation with good reason within this severance pay exception.  Thus, many employers were considering revising their deferred compensation documents to remove such “good reason” provisions (or were considering other steps to bring those documents into compliance with Section 409A).

THE FINAL REGULATIONS

The final regulations explicitly recognize that, in some cases, a voluntary resignation for good reason is functionally equivalent to an involuntary separation.  Where this is the case, both the short-term deferral exception and the involuntary severance program exception might now be available.

In order for a good reason resignation to be treated as an involuntary separation from service, the final regulations require that the conditions constituting “good reason” be specified in the plan or agreement, that the purpose of including those provisions was not to avoid the requirements of Section 409A, and that any voluntary separation under these conditions “effectively constitutes an involuntary separation from service.”

The final regulations further provide that any “good reason” provisions must refer to action taken by the employer that results in a material negative change in the executive’s employment relationship — such as the executive’s duties, the conditions under which those duties are to be performed, or the compensation to be received.  Those provisions should probably also specify that the amount of deferred compensation payable on a voluntary resignation for good reason is the same as that payable on an actual involuntary separation from service.  Finally, the provisions should require that the executive give the employer notice of the conditions believed to constitute “good reason,” along with an opportunity to remedy those conditions.

A regulatory “safe harbor” definition of a good reason termination incorporates many of these same requirements.  To fall within this safe harbor, a plan or agreement must incorporate the following provisions:

  1. A voluntary separation from service must occur within two years after the occurrence of one or more of six specified “good reason” events;
  2. The amount, time, and form of payment of any deferred compensation attributable to a good reason resignation must be the same as that attributable to an involuntary separation from service; and
  3. The executive must provide notice of the conditions believed to constitute good reason for a voluntary resignation within 90 days of their occurrence, with the employer given at least 30 days in which to remedy those conditions (and  therefore not pay the deferred compensation).

Employers and executives whose deferred compensation documents contain provisions for payment of deferred compensation on a voluntary resignation for good reason — or who believe that adding such a provision would make business sense — will want to review their existing deferred compensation documents.  If those documents are not consistent with the guidance provided in the final regulations, they should be revised by the end of this calendar year.  Assuming the other requirements for relying on either the short-term deferral or involuntary severance program exception are satisfied, such revisions will allow those documents to avoid complying with the constraints imposed by Section 409A.