By Alison Patel
Employers with employment agreements, severance policies, and other non-qualified deferred compensation agreements that contain language conditioning any payment on employee action, such as the execution of a release of claims, need to take action immediately to ensure such condition does not cause the agreement to violate Section 409A. In the event a release provision does not comply with Section 409A, employers have until December 31, 2012 to amend the offending language and take advantage of transition relief from Section 409A penalties.
The following types of deferred compensation arrangements are most likely to condition payment on an employee action (e.g., executing a release of claims, non-competition agreement or non-solicitation agreement, returning company property, etc.), and should be reviewed immediately if they do:
- Employment agreements providing severance benefits
- Severance pay plans or individual severance agreements
- Change of control bonus plans and individual agreements
- Other plans or agreements with severance benefit features
Employers should review these arrangements even if they were previously reviewed for compliance with the final Section 409A regulations.
Section 409A of the Internal Revenue Code imposes adverse tax consequences on the non-qualified deferred compensation agreements listed above unless the agreement satisfies numerous requirements or is otherwise exempt from Section 409A regulation. One requirement is that an individual receiving payment under a non-qualified deferred compensation arrangement cannot choose the tax year in which payment is made or begins. The IRS has taken the position that non-qualified deferred compensation arrangements that condition payment on the payee executing a release of claims, non-solicitation or non-competition agreement, or taking any similar action will violate this requirement, and therefore, Section 409A absent appropriate restrictions on payment timing.
As an example, consider an employment agreement that provides a severance payment following an involuntary termination of employment but states payment will not be made or begin until the employee’s execution of a release of claims. This violates Section 409A in two ways. First, it does not designate a specific payment date or period. Second, it allows the employee to control the tax year in which payment will be made because he or she can either execute the release in the current tax year or delay execution until a later tax year.
Same facts as Example 1, except the employment agreement provides that the release must be executed within 60 days of the termination of employment to receive payment and the payment must be made within 90 days of the termination of employment. The payment period designated (within 90 days of termination of employment) is compliant with Section 409A. However, even though the release period is limited to 60 days, it is viewed as not compliant. This is because an employee terminated at the end of a tax year can choose whether to execute the release at the beginning or end of the release period, thereby controlling the tax year in which it is paid.
Transition Relief Available
To the extent a deferred compensation arrangement violates the requirements of Section 409A, the amount payable under the arrangement is immediately includable in income and subject to an additional 20% tax and potential interest penalties. Fortunately, the IRS has issued guidance providing relief from these negative tax consequences to arrangements with the payment timing errors discussed in this alert. Employers can take advantage of this relief by correcting the offending plan or agreement, as follows:
- Agreements or plans that condition payment on employee action and also fail to properly designate a payment date or period under Section 409A (See Example #1) can be corrected by an amendment that provides for either (1) a payment on a fixed date either 60 or 90 days after the payment event occurs (e.g., termination of employment, change of control) or (2) a payment at any time during a specified period (up to 90 days) following the payment event under the condition that, if the period begins in one tax year and ends in the second tax year, payment will be made in the second tax year.
- A plan or agreement that only fails to comply with Section 409A because the employee has the ability to affect the year of payment by choosing when to sign the release during the designated period (See Example #2), can be corrected by an amendment that provides for payment on the last day of the designated period, or for payment in the second tax year in cases where the payment period starts in one tax year and ends in the second tax year.
Important Note: More favorable relief is available for arrangements that were entered into prior to 2011, if such arrangements are corrected no later than December 31, 2012. Notwithstanding the foregoing, arrangements entered on or after January 1, 2011, should also be reviewed and corrected as soon as possible, and in any event prior to a payment-triggering event, to avoid penalties under Section 409A.
- All deferred compensation arrangements that condition payment of benefits under such arrangement on the employee executing a release of claims or taking any similar action should be immediately reviewed for Section 409A compliance.
- To the extent a corrective amendment is required to comply with Section 409A, adopt an amendment (and obtain employee consent to such amendment, if necessary) prior to December 31, 2012, and comply with disclosure requirements set forth in IRS guidance.
- Review the internal process for drafting future agreements to ensure that release provisions violating Section 409A are not included in such agreements.
This alert provides only a brief summary of the potential risk and relief opportunities associated with this issue. If you have any questions or would like more information, please contact one of the attorneys in McAfee & Taft’s Employee Benefits and Executive Compensation Group. They are prepared to help you identify Section 409A failures in your plans or agreements and guide you through the correction process, if needed.
This publication has been provided for informational purposes only. It does not provide legal advice, and it is not intended to create a lawyer-client relationship. Readers should not act upon the information in this publication without seeking professional counsel. Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.