Year-End Deadline for Section 409A Document Compliance Correction

This advisory serves as a heads-up to review your deferred compensation plans and agreements NOW to be sure they have the “magic language” to be in compliance with Code Section 409A by year-end. Failure to make a simple document correction by December 31, 2012, could result in stiff tax penalties to unsuspecting employees.

What Should be Reviewed by Year-End?

At issue are severance and other compensation arrangements that are conditioned on the employee taking some kind of action—typically, signing a release of claims or entering into post-employment restrictive covenants. These arrangements are most likely to reside in:

  • employment agreements;
  • severance plans or agreements;
  • change-in-control arrangements; or
  • cash or equity-based incentive awards that pay out upon separation from service.  

What is the Problem?

In a typical example, an employee may be entitled to severance upon termination of employment, payable within a specified period (typically 60 or 90 days) following termination, but only if he or she signs a release of claims.

The IRS takes the position (first indicated in Notice 2010-6) that such a provision does not comply with Section 409A because, if the period spans two calendar years, the employee would able to time the recognition of income by when he or she signs the release. Many practitioners believe this position is not supported by the final 409A regulations and, therefore, many documents that were amended to comply with 409A in 2008 contain this type of problematic provision and need to be revisited.

What is the Solution?

In Notice 2010-80, the IRS specifies alternative methods for addressing the issue:

  1. If a plan document already provides a period after termination during which payment may be made, provided the employee signs the release (which the IRS deems to be a noncompliant provision), the plan may be amended to either (i) specify that the payment will be made on the last day of such period, or (ii) specify that if the period spans two calendar years, payment cannot be made before the second such calendar year, regardless of when the release is signed.
  1. If a plan document does not already provide a period after termination during which payment may be made, provided the employee signs the release, the plan may be amended to either: (i) provide that payment will be made on the 60th or 90th day after termination, provided the employee has signed the release, or (ii) provide for payment during a period (not longer than 90 days) after termination, provided the employee has signed the release, and specify that if the period spans two calendar years, payment cannot be made before the second such calendar year, regardless of when the release is signed.

In either case, the amendment cannot otherwise change the time or form of payment.

If the payments would be exempt from Section 409A (by reason of the short-term deferral exemption or otherwise), these special timing constraints would not be required. However, because it is not always determinable in advance that a payment will be exempt, many companies may decide to add the protective language just in case.

The amendment would generally be short and in some cases would not need to be reported to the IRS. If a report is required, there is some relief from the employee’s filing requirements.

What to Do?

Contact your attorneys as soon as possible to review the relevant documents for compliance. Any amendment will likely need to be signed by both the company and the employee, so allow time for the necessary communication, review and approvals.