Creating Pre-Tax Severance Benefits
Updated: Dec 18, 2020
When most people think about compensation, few think about severance as a form of compensation that they will ever receive. It is important to plan for all contingencies regardless of their likelihood. Severance from employment can occur for a variety of different reasons unrelated to your performance including a corporate change in control or ownership, a change in corporate leadership or just as a result of normal cost cutting. Severance benefits can make up a meaningful part of one’s annual compensation that often is not needed for a variety of reasons.
Depending on the length of severance, it may not take one that long to find another opportunity thus creating unnecessary excess compensation and taxes
Many may want to take time off upon separation but rarely does that last more than a few months
There may be other forms of compensation that may vest especially if one’s severance is the result of a change in control
For these reasons, many executives may choose to defer their severance benefits (or part of their severance) into a nonqualified deferred compensation plan and warehouse that cash on a pre-tax basis to be used at a future point in time.
While severance is not always thought of as a traditional form of compensation that one can elect to defer like salary or bonus, it can be included as a form of compensation that can be deferred. This is traditionally done through the “company contribution” provision within the plan that allows for the company to make discretionary contributions into the deferred compensation plan on behalf of the executive. When one is terminated from employment and severance is offered, the parties may agree to have some or all of that severance paid in the form of a company contribution to the deferred compensation plan.
How to Defer Severance
There are generally only three ways one can defer severance:
In the original employment or severance agreement the severance benefit or some percentage thereof is structured to be deferred
If severance has not been offered yet in the form of a formal agreement
If a current severance right exists at the time termination occurs, and the payout is not scheduled to occur less than 12 months after termination
Simply stated, if a severance plan already exists and there is a legal obligation in place to pay severance within 12 months after termination, then it is generally too late to defer the severance. It is this point that makes planning so paramount when including severance in one’s employment agreement; either severance needs to be elected to be deferred prior to a formal agreement going into place or the severance payments need to be designed to be delayed for at least 12 months after termination to allow the participant to make a further deferral election at the time of termination. This delay can allow one to accommodate IRC 409A by making an election to defer severance 12 months prior to the date is scheduled to be received. This will only be permitted if the executive defers the income for at least 5 years from the date they would have otherwise received the income.
If severance has not yet been offered, then one can elect to defer all or part of their severance prior to entering into a binding agreement to receive it. Having the ability to make a planning decision ahead of time could save an executive a lot of unnecessary taxes and provide him or her with an opportunity to accumulate wealth on a pre-tax basis for retirement purposes. If the income is not needed due to another job already being secured or the lack of need for additional income, deferring severance benefits can make a lot of sense from an overall planning perspective.