Severance as Deferred Compensation: What You Need to Know About Code Section 409A and Its Exemptions
Section 409A of the Internal Revenue Code (Section 409A) imposes strict rules governing the timing of deferred compensation payments, such as when and under what circumstances such payments can be made. It comes with significant penalties, imposing a 20% tax (and other adverse tax consequences) on non-compliant deferred compensation.
Is severance considered deferred compensation covered by Section 409A? The answer may be surprising.
In general, deferred compensation for Section 409A purposes is defined as a legally binding right arising in one calendar year to receive compensation that may be paid in a future calendar year.
Under that broad definition, an entitlement to severance under an employment agreement, severance plan or other contractual arrangement may qualify as deferred compensation, meaning that the severance would need to be structured to comply with Section 409A’s strict timing rules. However, there are also many exceptions to Section 409A.
The following table summarizes several common exemptions from Section 409A that apply to severance arrangements. One practical tip to keep in mind is that Section 409A allows multiple exemptions to be used for one arrangement — a concept known as “stacking” — such that severance amounts payable under a single arrangement may be divided among, and qualify for, more than one exemption. For more details on “stacking” and how some of the terms used in these exemptions are defined, see “Tricky Compliance Issues for Companies When an Executive Terminates Employment: 409A Applicability to Severance.”
Common Exemptions from Section 409A for Severance
| Exemption / Approach | Description | Key Requirements |
| Short-Term Deferral Exemption | Exempts payments that must, in all circumstances, be actually or constructively received by no later than 2½ months after the end of the year in which the compensation is no longer subject to a substantial risk of forfeiture. | Severance payments that become payable only upon an involuntary termination of employment without cause and that must be paid or constructively received by no later than March 15 of the year following the year of termination will generally qualify for this exemption. |
| Involuntary Separation Pay Plan Exemption | Exempts severance payments that are only made upon an involuntary separation from service (i.e., without cause or by the service provider for “good reason,” as defined under Section 409A), subject to limits on the amount and duration of the payments. | Payments must: (1) not exceed two times the service provider’s compensation for the year prior to separation from service (or, if less, two times the annual compensation limit for tax-qualified plans under Internal Revenue Code Section 401(a)(17) ($360,000 x 2 = $720,000 for 2026)), and (2) be paid no later than the end of the second taxable year of the service provider following the year in which the separation from service occurs. |
| Reimbursements of Business Expenses Exemption | Exempts separation pay plan payments of reimbursements that the service provider could otherwise deduct under Section 162 or Section 167 of the Internal Revenue Code as business expenses incurred in connection with the performance of services. | Exemption covers only reimbursement rights that apply to expenses incurred during a “limited period of time,” which generally includes only periods through the last day of the second year following the year in which the separation from service occurred. The period during which the reimbursements for such expenses must be paid generally may not extend beyond the third taxable year following the year in which the separation from service occurs. |
| Reasonable Outplacement and Moving Expenses Exemption | Exempts separation pay plan reimbursements of reasonable outplacement expenses and reasonable moving expenses actually incurred by the service provider (including reimbursement of actual loss incurred due to the sale of a primary residence) and directly related to the termination of services for the service recipient. | Exemption covers only reimbursement rights that apply to expenses incurred during a “limited period of time,” which generally includes only periods through the last day of the second year following the year in which the separation from service occurred. The period during which the reimbursements for such expenses must be paid generally may not extend beyond the third taxable year following the year in which the separation from service occurs. |
| Medical Separation Pay Plan Exemption | Exempts reimbursements of medical expenses allowable as a deduction under Internal Revenue Code Section 213 during the period in which the service provider could elect Consolidated Omnibus Budget Reconciliation Act (COBRA) coverage (generally 18 months). | Applies generally to the payment of medical premiums or reimbursement of medical expenses during the COBRA eligibility period. |
| Limited Payments Exemption | Exempts separation pay of limited amounts. | Payments must be under a separation pay plan and not exceed in the aggregate the applicable dollar amount under Internal Revenue Code Section 402(g)(1)(B) ($24,500 for 2026) for the year of the separation from service. |
To the extent an exemption is not available, severance can often be structured to comply with Section 409A. To comply, severance payments need to be triggered by a permissible payment event (such as death, disability, or a “separation from service” under Section 409A) and paid on a fixed schedule. For specified employees of a publicly traded company, payments triggered by a separation from service may also be subject to a mandatory six-month delay. If the service provider must sign a release, the payment generally must be payable on a fixed date that cannot vary between tax years depending on the timing of execution of the release.
For additional information, please contact any of the attorneys in Foley’s Employee Benefits & Executive Compensation Practice.
