Let’s say that you are negotiating your CEO’s new employment agreement. Because she is preparing for retirement, the CEO would like to be entitled to a stream of monthly lifetime separation payments upon her voluntary termination. This type of lifetime benefit makes sense for your company, and, based on the CEO’s long and faithful service to the company, you agree.
The CEO then asks for a provision calling for an immediate lump-sum payment upon her involuntary termination. The amount of the payment would be the present value, using reasonable actuarial assumptions, of the monthly separation pay annuity. This request seems reasonable – the fact that things may go sour in the future doesn’t change the fact of the CEO’s long service. And in an involuntary termination situation, who would want to receive payments over a period of time rather than in a lump sum? Should you agree to this request?
No. And regular readers of this blog will not be surprised as to why – Code Section 409A.
Code Section 409A generally requires that payments be made in a single form following each permissible payment triggering event. This means, for example, that a plan couldn’t provide for payment of an amount in a lump-sum if a change in control occurs in a January and a one-year stream of payments if a change in control occurs in a February. Payment forms can differ, however, if the permissible triggering event differs. It is permissible to call for payment of an amount over five years upon separation from service, but call for an immediate lump-sum payment of the same amount upon an intervening change in control.
There are quite a few exceptions to this rule. First, a payment upon a triggering event other than a separation from service can be in different forms on either side of an objectively determinable pre-specified date. For example, a change in control benefit could be paid in a lump-sum if the change in control occurs prior to a plan participant’s attainment of age 55 and could be paid in a life annuity if the change in control occurs after age 55. In essence, this exception permits a plan to “toggle” between two (and only two) forms of payment.
Separation from service payments can potentially “toggle” between three different forms of payment: a normal form of payment, a separate form for separations within up to two years following a change in control, and a final form for separations that occur before or after a specified date (or combination of a date and years of service). For example, an employment agreement could call for the same amount of separation pay to be paid in 36 monthly installments upon separation before age 62, a life annuity upon separation on or after age 62, and in a lump-sum if separation occurs during the year following a change in control.
What to do if your plan impermissibly toggles between forms of payments? The IRS generally permits correction by amending the plan so that the longest permissible forms of payment apply. And if the problematic triggering event occurs within one year of the date of correction, penalties could apply. As always, certain correction documents must be filed with the IRS.