Employee departures set off a complicated chain reaction affecting wages, equity, retirement benefits, and health coverage. Whether you’re dealing with a routine layoff, a negotiated separation, or a for-cause termination, the way you handle these benefits matters. Mistakes can prove costly, both financially and reputationally.
A comprehensive new resource from Foley & Lardner LLP walks through the minefield of compensation and benefits issues that arise when employment ends. The guide offers plan sponsors and their advisors a roadmap for navigating these often-tricky situations.
The first step in any termination situation is getting organized. Before taking action, gather all relevant documents: employment agreements, severance policies, bonus plans, equity award agreements, retirement plan documents, and insurance policies. The extent to which each document matters largely depends on whether the termination is for cause or not for cause—and here’s where things get complicated. The definition of “cause” in an employment agreement might differ from the definition in your bonus plan or equity award. You need to know which definition applies before moving forward.
Timing matters more than most people realize. Section 409A of the Internal Revenue Code governs when certain deferred compensation payments can be made. Get the timing wrong, and your former employee faces immediate income inclusion plus a 20% penalty tax. Before altering any payment terms, confirm that your revisions won’t create unintended tax consequences.
For retirement plans, the good news is that for-cause terminations generally shouldn’t affect vested 401(k) balances. The most important action item when an employee leaves is promptly notifying your third-party administrator so they can start the standard process for distribution rights and rollover options. If the departing employee has an outstanding 401(k) loan, you’ll need to communicate repayment options and default consequences according to your plan’s loan policy.
One common trap involves employee deferral contributions. Remember that severance payments are never eligible for 401(k) contributions or matching contributions. However, certain post-termination payments—like an employee’s final paycheck or accrued vacation payout—might need to have 401(k) deferrals withheld if they’re made within certain periods after employment and your plan document requires it. This is a frequent source of operational errors that require costly corrective action.
Health coverage triggers different obligations. The loss of group health coverage due to termination generally qualifies an employee for COBRA continuation coverage. If you’re subject to federal COBRA rules (generally employers with 20 or more employees), you must notify your COBRA administrator within 30 days of termination. The administrator then has 14 days to send out the election packet. If you administer COBRA internally, you have 44 days total to get that packet out. Small employers not subject to federal COBRA should check for state mini-COBRA requirements, which often impose administrative obligations on the employer rather than the insurance carrier.
Equity arrangements require careful attention. Award agreements and plan documents will specify whether unvested options, restricted stock, or performance awards are forfeited at termination or whether some form of accelerated vesting applies. For stock options, pay special attention to the post-termination exercise period. The standard window is 90 days, but extending that period requires care because modifications can affect the award’s tax treatment and create Section 409A problems.
For executives and key employees participating in nonqualified deferred compensation plans, the first question is whether the employee was fully vested at termination. Some plans impose additional forfeitures if the termination is for cause or if the employee violates post-employment covenants. If any portion of the account is vested, the plan document and employee deferral elections will dictate whether payment is due following separation. At public companies, specified employees face a six-month delay for most post-termination payments, and accelerations or re-deferrals of nonqualified plan payments are generally prohibited under Section 409A.
The Foley guide also highlights public company considerations that plan sponsors often overlook. Terminating a CEO, president, CFO, or other named executive officer triggers Form 8-K filing requirements with the SEC within four business days. Any compensation actions taken in connection with the separation may need disclosure in the next proxy statement. Section 16 officers present additional reporting complexities.
The bottom line for plan sponsors and advisors: benefit and compensation decisions when terminating an employee demand careful attention to plan documents, legal requirements, and timing rules. Accurately classify the termination consistent with applicable plan definitions. Gather and review all relevant documents early. Stay mindful of statutory deadlines, COBRA timelines, and payroll processing requirements. Avoid Section 409A pitfalls when altering payment timing or equity exercise periods. Document everything.
Approaching these situations methodically helps ensure you meet legal obligations, treat employees consistently with plan terms, and avoid the traps that lead to disputes or penalties.
