Attorney Comments on Planned Guidance on Excluded Bona Fide Severance Pay Plans, Amounts Subject to Substantial Forfeiture Risk

In connection with the issuance of IRS Notice 2007-62 (2007-32 IRB, 7/23/07) (the "Notice"), we respectfully submit the following comments concerning the definitions of a bona fide severance pay plan for purposes of Section 457(e)(11) of the Internal Revenue Code of 1986, as amended (the "Code"), and a substantial risk of forfeiture for purposes of Code Section 457(f)(3)(B), and related issues under Code Section 457(f).

Bona Fide Severance Pay Plans

In connection with the Service's anticipated issuance of additional guidance regarding the exclusion under Code Section 457(e)(11) for bona fide severance pay plans, we offer the following comments.

1. No Dollar Limit Should Apply. There should be no dollar limit for the severance pay exception under 457(e)(11). At the very least, the dollar limit based on the 401(a)(17) compensation limit should not be imposed under 457(e)(11). That limit, as included in the 409A regulations, was a regulatory creation, intended to ease the impact of certain of the 409A rules in limited circumstances. But 457's severance exception is statutory, and contemplates no such limit. Moreover, the ERISA definition of a severance plan provides for no artificial 401(a)(17) -- based dollar limit on the amount of severance benefits. Thus, no dollar limit should apply.

a. If, notwithstanding the discussion above, the IRS nonetheless does not eliminate the dollar limit for the severance pay exception, the guidance to be issued needs to, at a minimum, either include a provision treating the obtaining of a release of claims as a substantial risk of forfeiture, or else include a provision permitting severance pay in excess of the dollar limit that is paid during the first 2-1/2 months after the year of a separation from service as exempt from the otherwise applicable 457(f) rules. Including one of those provisions is essential, for example, to enable a severance payment, made in connection with a late December involuntary separation from service, to be paid in the following January or February, only after receipt of a valid ADEA release (which can require a 45 day period for consideration, and a 7-day revocation period), without triggering income inclusion in the prior year, and related required tax withholding. It is entirely inappropriate to subject amounts that may or may not be paid, depending on whether or not a release has been signed, to be taxed, and to trigger a requirement of payment of withholding taxes by the employer, at a point in time when, because the release has not yet been signed, it is not certain that any severance payment will be due or payable. This concern was not a problem prior to the suggestion made by Notice 2007-62 that the 457(e)(11) severance payment exception would be limited in amount. But if it is to be limited in amount, the opportunity to obtain a release prior to the taxation of the payment is essential.

2. Definition of Involuntary Separation from Service. The determination of whether an involuntary separation from service has occurred should otherwise reflect all aspects of the guidance provided under the Code Section 409A Final Regulations. See Treas. Reg. § 1.409A-1(n). Thus, an involuntary severance from employment should be deemed to occur upon (i) an employer's (service recipient) failure to renew an employment or other service agreement upon its expiration provided the employee (service provider) is willing and able to execute a new agreement and perform similar services, and (ii) a "good reason" termination (applying the same good reason rules as are provided in Treas. Reg. § 1.409A-1(n)(2)).

Reimbursements

While under the Notice the anticipated guidance to be provided concerning exempt severance pay plans is expected to include exceptions for, among others, reimbursements and in-kind benefit arrangements (herein collectively referred to as "reimbursements"), issues under Section 457(f) still need to be addressed concerning taxable reimbursements that are provided during an employee's employment, or after the end of the second taxable year following the year in which a separation from service occurs.

1. Reimbursements during Employment. The guidance should provide that if a taxable reimbursement is paid by the end of the taxable year following the year in which the related expense is incurred, then the payment should be taxable under Section 457(f) in the taxable year in which paid even if no substantial risk of forfeiture exists (i.e., no substantial services are required) beyond the end of the year the reimbursable expense is incurred. This treatment would afford employers a reasonable period to calculate and pay reimbursable amounts, and would not result in any inappropriate tax deferral.

2. After Separation from Service/Tax Gross-Up Payments. After an employee's separation from service, certain taxable reimbursements, especially tax gross-up payments, that can be made after the two-year period contemplated for post-separation exempt reimbursements should be considered to not involve the deferral of compensation for Section 457(f) purposes if they are paid in accordance with the specified date/fixed schedule rules under the Section 409A regulations. See Treas. Reg. § 1.409A-3(i)(1)(iv). Thus, such reimbursement payments or benefits, if taxable, should only be included in the employee's income in the taxable year the reimbursement amount or benefit is received by the employee (provided the reimbursement is paid by the end of the taxable year following the taxable year in which the reimbursable expense is incurred) even if no substantial risk of forfeiture exists following the employee's termination of employment. As noted, in particular for tax gross-up payments, which may be required several years after termination of service, this relief is essential. If such guidance is not provided, then this anomalous result could occur: the "vested" right to a future tax gross-up payment would be currently "taxable" under Section 457(f), yet the amount of such payment is unknown, and in fact may never be required to be paid.

Bonus and Incentive Payments

The new 457(f) guidance should provide that bonus and incentive compensation amounts (herein collectively referred to as "bonus amounts") that are paid within a short-term deferral period (applying the short-term deferral rules under Treas. Reg. § 1.409A-1(b)(4)) will not involve the deferral of compensation for purposes of Section 457(f) and therefore such amounts will be includible in income under Section 457(f) in the taxable year when paid whether or not the amount was no longer subject to a substantial risk of forfeiture following the taxable year in which the bonus amounts were earned. The use of a short-term deferral period would permit a short administrative time period following the taxable year in which the bonus amounts vest during which the bonus amounts could be properly calculated and payment made to the employee while at the same time avoiding any inappropriate tax deferral. Such an administrative period is particularly important where a bonus relates to quantitative or qualitative measures relating to a full calendar year -- which cannot be calculated until all results for the year have been tabulated. To avoid abuse, the guidance could require that the actual timing of the payment would rest with the employer, not with the employee. See Treas. Reg. § 1.409A-3(b) (which permits payment within a 90-day period as determined by the employer (service recipient) even if the 90-day period straddles two taxable years). Such an approach, which has a well-settled basis in the 409 A regulations, would permit a reasonable and common business practice concerning the calculation and final determination of bonus amounts shortly after year end to continue and would avoid the inappropriate and unfair need to condition payment of a bonus on continued service into the following tax year to avoid early income inclusion and withholding obligations before the amount of the bonus has been calculated.

We greatly appreciate the opportunity to offer comments with respect to Code Section 457(f) and the anticipated guidance thereunder as outlined in the Notice. If you have any questions about the suggestions made in this letter, we would welcome the opportunity to discuss them with you.