Want to offer severance?

Consider Section 409A

If an employer intends to enter into an agreement with an employee pursuant to which the employer agrees to pay severance upon the employee’s termination of employment, the employer should, as part of the separation process or when structuring future severance entitlements, determine whether the terms of such severance comply with, or are exempt from, the provisions of Section 409A of the Internal Revenue Code. Section 409A restricts the timing of when certain deferred compensation payments, which may include severance, may be paid to employees and imposes harsh tax penalties on the employee if the terms of such compensation do not follow such rules.

In general, Section 409A does not apply to severance. Most severance is exempt from Section 409A, because the terms of the severance provide that it will be paid before March 15 of the year that follows the year of the employee’s termination. This tends to be the case if the severance is paid all at once in a lump sum or over a short period (e.g., one or two months) following termination. Section 409A does not cover such severance, because a compensatory payment that cannot be paid later than March 15 of the year following the year in which the employee has a substantially non-forfeitable right to the payment is not considered a deferral of compensation under Section 409A.

Although Section 409A generally does not apply to severance, there are traps for the unwary under Section 409A. For example, the severance agreement should provide that, if the period for the employee to consider and revoke the release of claims included in the agreement or as a separation condition for severance could span two calendar years, then the employer may not pay the severance until the second calendar year. The purpose of this provision is to prevent the employee from using such period to game the tax year in which the severance is paid.

In contrast, if the employer pays the severance in installments following termination and such payments may be made later than March 15 of the year following the year of termination, then such severance may be subject to Section 409A. For example, severance that is paid in installments over one year following termination may be subject to Section 409A, as some of the payments will be made later than March 15 of the year following the year of the employee’s termination.

Section 409A offers another exemption that covers many such severance arrangements if the severance is only paid on the employee’s termination without cause and meets certain other conditions. Under the “separation pay exemption,” a severance agreement that provides that severance may only be paid to an employee on the employee’s involuntary termination does not provide for a deferral of compensation subject to Section 409A if the severance payment: (1) does not exceed two times the lesser of either the sum of the employee’s annual pay for the year prior to the year of termination, or the maximum amount that may be taken into account under a qualified plan pursuant to Internal Revenue Code Section 401(a)(17) for the year of termination (which for 2026 is $360,000); and (2) is paid no later than the last day of the second taxable year of the employee following the taxable year in which the termination occurs.

An involuntary termination is a termination by the employer that is not at the employee’s request and occurs when the employee was willing and able to continue performing services. In general, this means a termination by the employer without cause and not due to the employee’s voluntary resignation. In some cases, an employee’s resignation due to good reason may be considered an involuntary termination for this purpose. Careful attention should be paid to how “good reason” is defined to ensure it qualifies as an involuntary termination for purposes of Section 409A. Note, this separation pay exemption also applies to a termination pursuant to a window program, but discussion of this prong of the exemption is outside the scope of this article.

Section 409A permits the “stacking” of exemptions such that, if applicable, the portion of the severance payable before March 15 of the year following the year of termination may be treated as exempt under the shortterm deferral exception and a portion may be exempt under the separation pay exemption. This may result in all of the severance being exempt from Section 409A even if neither exemption individually results in all of the severance being exempt. However, to take advantage of this ability to stack exemptions, the agreement should state that the installment payments under the agreement are treated as separate payments, so that each payment is considered separately for purposes of assessing the applicability of the exemptions.

To ensure that severance is not subject to Section 409A or, if necessary, complies with Section 409A, employers should consult with legal counsel versed in Section 409A and its complicated rules.

Madeline Lewis is a corporate and tax attorney at McLane Middleton with experience advising businesses and individuals on compensatory, employee benefits and employment-related matters in corporate transactions and in day-to-day business management. She can be reached at madeline.lewis@mclane.com or 603-628-1330.