Executive employment relationships are rarely permanent. When an executive or other senior-level employee terminates employment, companies often must deal with difficult tax, equity, and benefits issues that arise in connection with the employee’s termination.

This article is the second in a series of articles that address important compliance pointers for structuring post-termination benefits or addressing issues and considerations for companies when an executive terminates employment.

Last month, we discussed whether ERISA applies to your executive severance plan. This month, we are diving into the applicability of Section 409A of the Internal Revenue Code (Section 409A) to severance benefits. Specifically, this article discusses the difference between Section 409A compliant vs. Section 409A exempt severance, and how that impacts your approach to severance entitlements.

Exempt vs. Compliant Severance

Practitioners will sometimes use the phrase “409A Compliance” to refer generally to a payment arrangement that is drafted to avoid the 20% excise tax and other penalties prescribed by Section 409A. This can be achieved by either structuring payments to meet one of the exemptions in Section 409A or by structuring payments to meet all of the compliance requirements of 409A (i.e., payments can either be EXEMPT FROM or COMPLIANT WITH Section 409A). While both 409A exemption and compliance prevent the employee from adverse tax outcomes, there are certain nuances in how exempt vs. compliant payments are treated under other provisions of Section 409A. As a result, it is important to understand whether promised severance payments are intended to be 409A exempt or compliant.

409A Exemptions for Severance

There are generally two exemptions available for severance benefits: (1) the short-term deferral exemption, and (2) the separation pay plan exemption.

Short-Term Deferral

To be considered a short-term deferral, the severance payments must meet the following two requirements:

1. The severance is only paid upon an “involuntary separation from service” (see the section below entitled “What Qualifies as an Involuntary Separation from Service?” for more information); and
2. The severance is required to paid in its entirety, by its terms, no later than March 15^th of the year following the year of the employee’s separation from service (or, if later, the 15^th day of the third month of the company’s taxable year in which the termination occurs).

As a result, severance benefits that are payable in a single lump sum shortly after termination of employment should generally be exempt from Section 409A as a short-term deferral. However, be mindful that even when cash severance is payable in a single lump sum, other taxable benefits (such as medical insurance continuation) may be paid or provided over a period of time, and as a result, such benefits must be analyzed separately.

Separation Pay Plan

Severance payments that meet all of the following three requirements are also exempt from Section 409A under the separation pay plan exemption:

1. The severance is only paid upon an “involuntary separation from service.”
2. The total amount of severance does not exceed two times the lesser of (a) the employee’s annual compensation for the prior taxable year or (b) the IRS 401(a)(17) limit (which is US$350,000 for 2025) (the “Separation Pay Cap”).
3. The severance is required to be paid by its terms no later than December 31^st of the second year following the year in which the separation occurs.

What Qualifies as an Involuntary Separation from Service?

For this purpose, an involuntary separation from service means that the employee either was terminated by the company when the employee was willing to continue providing services or resigned with “good reason,” provided that the good reason definition is limited to material negative changes in the employment relationship. The Section 409A regulations include a safe harbor definition of good reason that is generally prudent to follow when relying on either of the exemptions described above. (See Treasury Regulations § 1.409A-1(n)(2)(ii).) This safe harbor definition provides the conditions that can establish good reason as well as the process that the employee must follow to claim good reason (including providing the company with timely notice of the event alleged to constitute good reason and a reasonable opportunity to cure the good reason condition, and actually terminating employment within a short period of time thereafter).

Also, as a reminder, while “separation from service” generally aligns with a layperson’s understanding of termination of employment, extra attention must be given when an executive continues as a consultant or other part-time position for some transition period after their cessation of regular employment. Depending on their expected continued level of services as a consultant, their “separation from service” for purposes of Section 409A rules could either occur at their termination of employment date or at the later date when they cease to be a consultant.

Stacking Exemptions

Often, an executive’s total severance package exceeds the maximum amount permitted to be exempt from Section 409A under the separation pay plan exemption. For example, in 2025, the maximum amount of severance that can fit under the separation pay exemption is US$700,000 (i.e., twice the US$350,000 401(a)(17) limit). For higher-paid employees, often whom receive severance that is worth more than one year of base salary, it can be easy for this US$700,000 limit to be exceeded.

If such higher severance amounts are paid in installments, then can it ever be exempt from Section 409A? Potentially yes, by relying on a Section 409A concept that allows you to “stack” the short-term deferral and separation pay plan exemptions. Under this concept, you can treat the portion of the installments that will be paid during the short-term deferral period as short-term deferrals, and the remainder as separation pay. By stacking these exemptions, it is possible for more than US$700,000 of severance payments to be exempt.

409A Compliant Severance Arrangements

To the extent severance benefits are not exempt from Section 409A, then the non-exempt portion of the benefits must comply with Section 409A. This requires that:

• Payments can only commence upon a “separation from service” (see note above regarding tricky situations where executives continue as a consultant after employment).
• Payment dates must be specified in the agreement in an objective manner, and cannot be subject to any employee or employer discretion to change payment timing (whether directly or indirectly). Note, this may also include payment timing considerations if the executive is required to execute a release of claims to receive severance benefits and the release consideration period could span between two calendar years.
• With limited exceptions, there must be a single payment schedule for all separations from service to comply with Section 409A’s “anti-toggling” rules.
• If the executive is a “specified employee” within the meaning of Section 409A (generally, one of the top 50-paid officers of a publicly traded company), then the non-exempt severance pay must be delayed for at least six months after the executive’s separation from service.

Although the most common scenario when severance must comply with Section 409A is when the severance is paid in installments and exceeds the Separation Pay Cap (even with utilizing any “stacking” of the short-term deferral exemption with the separation pay plan exemption), the other time the exemption can be lost is when the definition of “good reason” is too executive-friendly, e.g., the executive can trigger terminating employment for good reason on one or more circumstances that is not considered a material adverse change to the executive’s working conditions. In this latter event, none of the severance pay would qualify for any Section 409A exemption because the severance pay would not be considered to be paid due to an “involuntary separation from service” as Section 409A defines it.

Differences Between Exempt vs. Compliant Severance

As noted above, while both 409A exempt and 409A compliant severance avoids the 20% penalty tax, there are meaningful differences between how exempt vs. compliant severance is treated under other Section 409A rules. Specially, if severance is exempt from Section 409A, then:

• The severance payments can be accelerated without penalty. For example, severance that is originally required to be paid in installments, but is exempt under the separation pay plan exemption, can be accelerated and paid in a lump sum without causing problems under Section 409A.
• The severance package may be able to be replaced with a new arrangement with different payment terms without a Section 409A “substitution” risk that is inherent when 409A compliant arrangements are replaced.
• The six-month delay that applies to specified employees at public companies does not apply to exempt severance.

In practice, the first two bullets above can be especially invaluable because it is not uncommon for either the executive or the company to want to renegotiate severance terms at some point during the employment relationship or at the time of a separation. So, parties typically prefer to structure severance as exempt from Section 409A to the extent possible for maximum flexibility down the road. And, if you are currently facing an executive separation and severance obligations, make sure to confirm whether your severance is exempt from, or complies with, Section 409A before agreeing to any changes in the payment terms.