Severance agreements – especially severance agreements for terminating executives – are ripe with potential tax planning challenges and opportunities. Before you draft your next agreement, beware of the following three traps:
Trap 1: Giving the Employee the Choice Between a Lump Sum Payment and Monthly Installments
In an effort to give employees a choice and more flexibility in their financial planning, some employers give employees the choice between a lump sum severance payment and monthly installments. While this approach seems reasonable, this design raises two potential issues:
Trap 2: Employer-Paid COBRA Benefits
Employers may elect to supplement the cost of COBRA continuation coverage for certain terminating employees. For example, it is fairly typical for employers to provide that the terminating employee will only be responsible for paying the “active employee” rate for all or part of the standard 18-month COBRA period, rather than the 102% COBRA rate. While this seems reasonable, it creates two potential tax issues:
Trap 3: Timing of a Release
If the severance pay is not exempt from Section 409A (as a short-term deferral or involuntary separation pay) and (1) the employee is required to sign a release as a condition to payment and (2) the timing of when the employee signs the release will impact the calendar year in which some or all of the severance is paid, then this will create a problem under Section 409A. For example, if the first of 36 installment payments is made as soon as the employee’s release of claims becomes irrevocable, then there is a Section 409A error which will result in immediate taxation of the full value of the severance benefit and an additional 20% income tax on the employee.