Proposed 457(f) Regulations Summary: Severance Pay

PROPOSED 457(f) Regulations: Bona Fide Severance Pay Plan

One of the primary terms that the proposed 457(f) regulations define is “bona fide severance pay plan.” Severance payments do not vest except upon certain types of termination of employment, and so are not deferred compensation for 457(f) purposes. This post summarizes how the proposed regulations define bona fide severance pay plans and what types of severance can give rise to them.
The regulations articulates three requirements that a severance pay plan must meet to be exempt from general deferred compensation treatment:

  1. The amount of the severance benefit cannot exceed two times the participant’s total annual compensation. Amounts in excess will be taxable in a lump sum at the beginning of the severance period, even if not paid until later.
  2. The entire severance benefit must be paid by the end of the second calendar year following severance, and a written plan document must specify such.
  3. The benefits may only be payable upon involuntary severance from employment, or upon voluntary severance from employment for good reason. The 457(f) regulations define these two as follows:
    o “Involuntary severance from employment” occurs when the employer independently exercises “unilateral authority to terminate the participant’s services, other than due to the participant’s implicit or explicit request, if the participant was willing and able to continue performing services.” For example, an employer may decline to renew a contract upon its expiration, even though the employee remained willing and able to renew its terms. Whether a termination was involuntary is determined based on the facts and circumstances, regardless of how the employer or participant characterizes it.
    o “Severance from employment for good reason” occurs if the participant voluntarily terminates employment because the employer caused a “material negative change” to the participant’s relationship with the employer, to such a degree that it effectively amounts to involuntary termination. Some examples include material reductions in duties or compensation, or relocation or similar negative changes in the working conditions. However, the voluntary severance from employment must happen in accordance with conditions pre-specified in writing, and the primary purpose of the separation must not be to avoid section 457.
    Safe Harbor. A voluntary severance is deemed to be for good reason if it meets the following safe harbor conditions:
    ♣ The severance occurs within two years of the good reason arising, the reason arises without the participant’s assent, and the conditions amounting to good reason are specified in writing at the time the legally binding right to payment arises.
    ♣ The terms of the severance payment are substantially the same is if the severance had happened involuntarily.
    ♣ The participant provides notice to the employer of the existence of the applicable condition and provides the employer a period of at least 30 days to remedy it.