What you need to know:

If severance arrangements condition payments upon the execution of a release of claims, they may allow a terminating employee to exercise discretion over the date of commencement of the severance payments in a manner that violates Section 409A of the Internal Revenue Code.

What you need to do:

Employers should carefully review their severance agreement release language and make corrections as needed to ensure compliance with 409A.

Section 409A of the Internal Revenue Code governs the time and form of payment under traditional non-qualified deferred compensation arrangements as well as payments made under certain severance, employment, retention and change in control agreements (collectively, a “severance arrangement”). Importantly, a severance arrangement is exempt from Section 409A if payments are made only upon an involuntary termination, including resignation for a Section 409A-compliant “good reason.” To qualify for the exemption, severance must either be paid in full by March 15th of the year following termination (the so-called “short term deferral exception”), or if the amount paid does not exceed the lesser of $500,000 or two times the individual’s regular pay, be paid by December 31st of the second year following termination of employment (the so-called “involuntary separation pay exception”).

Severance arrangements that are not so exempt from Section 409A and which condition the payments upon the execution of a release of claims need to be carefully reviewed (and possibly amended), as they may allow a terminating employee to exercise discretion over the date of commencement of the severance payments in violation of Section 409A.

A Common Problem

Employees are often given a period of time to consider whether to execute a release of claims (generally 21 to 45 days, depending on whether the termination covers an individual or a group) and a seven-day period to revoke any executed release as required by the Age Discrimination in Employment Act. For example, a severance arrangement might provide that an employee will receive severance payments for a stated duration after the employee has returned an executed release of claims and has not revoked that release. Often an agreement will state that the employee has a stated period of time to consider and accept the offer but is unclear on when the payments commence. Sometimes a severance arrangement may provide that payment will commence “within” a stated period of time, such as 30 days after receipt of an executed and unrevoked release of claims.

In such cases, particularly when a termination occurs late in a calendar year, the employee is viewed by the IRS as controlling the year in which payments of deferred compensation commence, or in the case of a lump sum payment, the year of payment. According to the IRS, such release of claims provisions do not comply with Section 409A and could subject individuals to significant adverse tax consequences such as accelerating the year of inclusion of the severance payments in income, and the imposition of a 20% tax penalty and interest.

One Solution

If a severance arrangement is subject to Section 409A (i.e., it is not exempt under the short-term deferral exception or the involuntary pay exception), then the parties may avoid the tax penalties described above by correcting the impermissible release language as follows:

  • If the arrangement requires payment within a specified period after termination of employment, the arrangement must be amended to either:
    • Provide for payment only on the last day of that period, or
    • If that period straddles two calendar years, provide for payment in the later year regardless of when the release is received.
  • If the arrangement does not require payment within a specified period, the arrangement must be amended to either:
    • Provide for payment 60 or 90 days after termination of employment, or
    • Provide for payment during a period no longer than 90 days after termination of employment, but always during the later year if the period straddles two calendar years.

The correction must occur before the employee’s termination of employment. In addition, unless the transition relief for severance arrangements described below applies, both the employer and the employees must attach a statement of correction to their federal tax returns.

Transitional Relief

If a severance arrangement is subject to Section 409A and was in existence as of December 31, 2010, then under IRS guidance the employer may retroactively correct the release provision by December 31, 2012, as described above, but the employee need not attach any statement to his or her 2012 tax return. Unfortunately, the transitional relief provides that if payments are due in a period straddling two years, the agreement must be corrected to provide that payments will be made in the later year. If payments have already commenced, the parties must correct under a separate IRS program for operational 409A violations. Although a statement of correction must be filed by the employer with the IRS, no amendment is necessary if all payments under the severance arrangement will be completed by December 31, 2012. No correction (amendment or IRS statement) is required for non-compliant severance arrangements that were fully paid out before March 31, 2011.

Another Possible Solution

Understandably, some employers may be reluctant to notify the IRS of potential non-compliance with Section 409A. Such taxpayers should nevertheless amend their severance arrangements as soon as possible to correct the problematic release language. As long as such correction occurs both prior to the year of the employee’s termination and prior to the issuance by the IRS of final regulations regarding the method of calculating Section 409A-related penalties, the parties may be able to preserve an argument available under the proposed Section 409A penalty regulations (although the IRS may not concur) that severance arrangements which are subject to but do not comply with Section 409A may be corrected without notice to the IRS or the payment of penalties.

Note that severance payments contingent upon the execution of a noncompete agreement or a nonsolicitation present similar issues, although in most cases these agreements are almost always accompanied by a release of claims.