Among the many tax issues implicated by separation arrangements are two relatively new developments that may require special attention when drafting offer letters, severance plans, release agreements, change in control arrangements and similar separation arrangements.  Employers should review their separation arrangements by year-end to address these new developments.

The Deferred Compensation Tax Rules of Code Section 409A and the Problem of Conditioning Separation Pay on Employee Action, Such as the Execution of a Release (Notice 2010-6)

Notice 2010-6 generally established a procedure for plan sponsors of Code Section 409A plans and agreements to voluntarily correct "eligible" document failures (similar to the procedure for operational errors under Notice 2008-113).  But to the surprise of many, Notice 2010-6 emphasized the need for document correction based on the premise that certain arrangements which condition separation pay or certain other severance benefits on the employment-related action of an employee (such as the execution of a release of claims, noncompetition agreement, nonsolicitation agreement or similar condition) may cause the separation pay to be subject to or violate the requirements of Code Section 409A. 

Separation pay may be exempt from Code Section 409A and its significant penalties if such pay fits within one of several limited exemptions.  If separation pay is not exempt from Code Section 409A, Notice 2010-6 sets forth two ways for an employer to address an existing separation pay arrangement that is conditioned on an employment-related action without violating 409A:

  • If the agreement provides for payment (subject to the employee's action) within a designated period of time following separation from service, the agreement must provide for payment on the last day of such designated period.  For example, if the agreement provides for either a 21- or 45-day period for the employee to complete the employment related action and then a 7-day revocation period, the payment date could be set following the last day of the revocation period, such as on the 29th or 53rd day, respectively.
  • If the agreement does not provide for payment (subject to the employee's action) within a designated period of time following the permissible payment event, the agreement must provide for payment only upon a fixed date that is either 60 or 90 days following the occurrence of the permissible payment event. 

Health-Care Reform and the Problem of Continuing Health Insurance Coverage for Highly Compensated Individuals After Separation From Service (Notice 2010-63)

The widely publicized health care reform legislation in the Patient Protection and Affordable Care Act ("PPACA") provides that a group health plan (other than a self-insured plan) must satisfy the requirements of Code Section 105(h)(2) regulating certain "discrimination" in eligibility or benefits under the plan.  Historically, these nondiscrimination requirements applied only to self-insured group health plans, but PPACA extended the requirements (for plan years beginning on or after September 23, 2010) to fully insured plans underwritten by an insurance carrier.  A potential trap for many employers is how to deal with the payment of COBRA premiums or retiree medical benefits on behalf of former highly compensated individuals.  Notice 2010-63 provides initial guidance on this subject.

Fully insured plans that violate the nondiscrimination requirements of Code Section 105(h)(2) are now subject to the following sanctions under PPACA: (1) an excise tax equal to $100 per day per individual discriminated against for each day the plan does not comply with the requirement; and (2) a civil action under ERISA to enjoin a noncompliant act or practice or for appropriate equitable relief. 

Self-insured plans, on the other hand, continue to receive different treatment.  If a self-insured plan fails to comply with Code Section 105(h), certain highly compensated individuals may have premium or benefit amounts included in their gross income but the plan sponsors of such plans are not subject to either of the above PPACA sanctions.  In response, some employers sponsoring self-insured plans have included the value of any special employer coverage in the gross income of former highly compensated individuals and adopted a tax position that such treatment has converted the coverage from employer-paid to employee-paid and thus arguably negated the application of Code Section 105(h).  This approach may not be available for fully insured plans under PPACA. 

Providing health coverage after the termination of employment by a way other than through regular COBRA coverage paid by the employee or through a broad-based program can be problematic.  One possible solution is provided in the preamble to the regulations on grandfathered plans under PPACA, which provides that retiree-only plans are generally exempted from PPACA.

Practical Tips

  • Prior to the year-end, employers should review all severance arrangements, including those described above.  If a change is required to address a condition requiring an employment-related action by an employee, an employer may be able to take advantage of certain 2010 transition relief provided under Notice 2010-6 or other relief.
  • Plan sponsors should carefully review all fully insured group health plans to determine an appropriate response to PPACA’s nondiscrimination requirements if the plans are not treated as grandfathered or exempted plans under health care reform.

Additional Information

This Update provides only a general summary of Notices 2010-6 and 2010-63. You can read the full text of Notice 2010-6 here and Notice 2010-63 here.  You can also find additional discussions of Section 409A and of other recent cases, laws, regulations, and rule proposals of interest on our firm website http://www.perkinscoie.com/.

© 2010 Perkins Coie LLP


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