Tying the timing of severance payments to the date on which an employee returns an executed release of claims is a common practice in employment and separation agreements. This method, however, can result in severe adverse tax consequences under Section 409A of the Internal Revenue Code if the agreement is not drafted in compliance with guidelines issued by the Internal Revenue Service (the “Service”). This client alert outlines steps an employer may take to avoid these adverse tax results and explains why an employer should bring its agreements into compliance by Dec. 31, 2012.
Section 409A’s Stringent Regime
Section 409A imposes numerous complex rules and restrictions on arrangements that provide for the payment of non-qualified deferred compensation (which can include severance benefits, as described below). Failure to comply with these rules results in severe tax penalties on an employee that generally include:
- The immediate inclusion of the deferred compensation (even if not yet paid) into the employee’s income;
- Imposition of a 20 percent additional income tax; and
- Special interest tax penalties.
Even a minor or incidental violation can trigger these consequences. A violation will generally occur when a plan document or an agreement provides for the mere possibility of an improper payment – even if the actual payment would otherwise be compliant.
One of Congress’ goals in enacting Section 409A was to prevent the manipulation of when deferred compensation is paid. The Service has taken the position that linking the commencement of deferred compensation payments to the time that an employee takes some particular action, such as returning an executed release of claims, creates an opportunity for manipulation that is impermissible under Section 409A.
409A’s Impact on Severance Benefits under Employment & Separation Agreements
Section 409A generally defines a deferred compensation arrangement to include one in which an employee receives a legally binding right to compensation in one taxable year that is or may be payable in a later taxable year. As such, the scope of Section 409A extends far beyond what is commonly thought of as “deferred compensation” and it can often include arrangements that provide for severance benefits.
The regulations under Section 409A do provide for certain exclusions applicable to severance pay arrangements and a carefully drafted agreement can ensure that some or all of its severance benefits fall outside of Section 409A’s reach. However, these exclusions are limited and generally require that compensation be paid within a certain period of time following an employee’s termination of employment and/or limit the amount of severance benefits that can be paid. For example, involuntary separation pay is excluded from the scope of Section 409A if:
- It does not exceed the lesser of $500,000 or two times the employee’s annual compensation; and
- It is completely paid by no later than the end of the employee’s second taxable year following the year of separation.
Employment and separation agreements often condition the receipt of severance payments on an employee executing an agreement to release all claims against his or her employer. That, in and of itself, does not cause a Section 409A violation. Where a violation might occur, however, is when the agreement ties the timing of the payment of those severance benefits to when an employee executes or returns an executed release of claims. In the view of the Service, this permits an employee to manipulate the timing of when he or she would be subject to income tax on the severance benefits.
For example, an employee who is terminated on Dec. 1, 2012 could sign and return a release promptly so that he or she could begin receiving severance benefits in 2012. However, if the agreement does not otherwise prevent it, the employee could, for personal tax planning purposes, wait until Jan. 1, 2013 to sign and return the release, so that all of his or her severance benefits would be received in 2013 or later.
The above scenario would be a violation of Section 409A, regardless of when the employee actually returned his or her release – and even if the employee has no intention of manipulating the timing of the payment. This is considered a violation because the agreement allowed the employee to essentially choose the year in which to begin his or her severance benefits.
Although many practitioners believe that the Service’s fears are exaggerated, the Service maintains that such potential manipulations are one type of abuse that Section 409A was intended to prevent.
How This Works: 2 Examples
The following examples illustrate the difference between compliant and non-compliant provisions. Assuming that no Section 409A exclusions were applicable, the Service would likely take the position that the following provision violates Section 409A because the employee could theoretically manipulate the timing of the severance benefit:
Example #1: Upon her termination of employment without cause, Smith will be entitled to a severance benefit equal to two times her base salary, payable in 24 monthly installments, commencing with the first payroll date following her return of an executed release of claims.
In contrast, the following provision would likely not violate Section 409A because the timing of the payment is fixed:
Example #2: Upon his termination of employment without cause, Jones will be entitled to a severance benefit equal to two times his base salary, payable in 24 monthly installments commencing 45 days after the date of such termination, if and only if Jones returns an executed release of claims within 30 days of such termination and Jones does not revoke such release of claims.
In this case, the severance benefits are still conditioned upon a release being returned, but the timing of when the release is returned affects whether Jones receives benefits, as opposed to when he begins to receive them.
Correcting Non-Compliant Agreements:Notice 2010-80
If an existing employment or separation agreement provides an impermissible link between the timing of the payment of severance benefits and the date on which an executed release is returned, it is not sufficient to simply amend the agreement to incorporate a provision similar to the second example above. Instead, to avoid a Section 409A sanction, correction under Notice 2010-80 must be made by Dec. 31, 2012. The correction methods in Notice 2010-80 generally require an employer to prohibit an employee from delaying or accelerating the timing of a severance benefit.
Correction Method #1 – Fixed Payment Date: If an agreement already requires that a severance payment occur within a specific number of days of termination, subject to the employee’s execution of a release (e.g., “Severance payments will begin within 90 days after separation provided the employee executes a release”), the employer may revise the agreement to indicate that the severance payment will be made on the last day of that specified period (up to a maximum of 90 days). Alternatively, if the agreement does not contain a “fixed period,” the employer may revise the agreement to state that payment will be made on a fixed date either 60 or 90 days following the employee’s separation from service.
Example of Correction Method #1: Smith will receive a severance benefit of three times her base compensation on the 90th day following her involuntary separation from service; provided, however, that no payment shall be made unless Smith has executed a release that is in effect at the time payment is due.
Correction Method #2 – Later-Year Payment: Under the second correction method, the employer may revise the agreement to state that, if payment could occur during either of two tax years, the payment will be made during the latter of the two years. For example, if an employee was terminated on Dec. 15, 2012 and payment was to be made within 60 days of the employee’s termination subject to the employee’s execution of a release, the correction method would require payment in 2013 – regardless of whether the employee executed the release in 2012. The permissible period for paying the severance benefit using this correction method would be the period under the original agreement or, if no payment period was specified, a period of not longer than 90 days. This method has the advantage of allowing for earlier payment than the first method in many situations; however, it has added the complexity of requiring employers to use a different rule depending on the time of year an employee’s employment is terminated.
Example of Correction Method #2: Jones will receive a severance benefit of three times his base compensation following his execution of a release no later than 90 days following his involuntary separation from service; provided, however, that if payment of the severance benefit could be made in two taxable years under this provision, it shall be paid in the second taxable year.
Correction Without Penalty: Many employment and severance agreements containing non-compliant release provisions may be corrected without penalty if the correction is made by Dec. 31, 2012. Corrections are generally available for non-compliance with Section 409A, so long as (1) the agreement was in place as of Dec. 31, 2010 and (2) any payments occurring after March 31, 2011 that could be spread over two years were or are paid in the latter year.
An employer will be required to report any correction to the Service via a disclosure statement attached to the employer’s federal tax return. However, if the non-compliant release provision is corrected by Dec. 31, 2012, the employee will not be required to attach a copy of the disclosure statement to his or her tax return (which is usually required under the Service’s document correction program).
If the correction is not made by Dec. 31, 2012, or the agreement is not eligible for correction under Notice 2010-80, a correction may still be made in most circumstances. However, the affected employee will be required to report the correction on his or her tax form. Furthermore, depending on the timing of the correction as it relates to the employee’s separation from service, the employee may be subject to immediate income exclusion of 50 percent of the severance benefit, as well as a 20 percent additional income tax on that amount.