Take-Away: The IRS frowns on arrangements that allow someone to "game the system" and shift income back and forth across tax years. If a severance payment isn't due until after the departing employee signs a Waiver and Release, then the employee can theoretically hold off signing long enough to move the income into the following tax year. Employers need to amend their plans by the end of this year to prevent this.
Background and Explanation: Section 409A of the Internal Revenue Code generally requires that payments made under a deferred compensation plan must be made upon the occurrence of a trigger event (e.g., separation from service). For example, a deferred compensation plan that provides for payment of a lump sum on the sixtieth day after separation from service complies with this timing requirement. By contrast, an arrangement that provides for distribution at any time within six months after separation from service does not comply.
A deferred compensation plan that conditions payment upon the execution of a release of claims (or a similar employee action) will not comply with the timing requirement if the employee can affect the timing of payments by taking the required action sooner or later.
Deadline: In Notice 2010-80, the IRS addressed the timing issues where payment is contingent on employee action and provided transitional guidance for Section 409A compliance. The transitional guidance allows arrangements to comply with Section 409A without the need for plan amendments for periods before December 31, 2012. However, non-compliant arrangements must be amended to comply with Section 409A by no later than December 31, 2012.
How to comply: A non-compliant arrangement (i.e., an arrangement under which the employee can affect the timing of payments by taking the required action sooner or later) can be corrected by any of the following amendments:
- An amendment that removes the requirement that the employee execute a release and waiver to receive payment following a trigger event. This type of amendment is probably not in the employer's best interests.
An amendment that provides for payment during a specified period not longer than 90 days following the occurrence of the trigger event under the following conditions:
- the employee must execute the release (and the revocation period must expire) before the end of the specified period, and
- if the specified period begins in one taxable year and ends in a second taxable year, the payment will be made in the second taxable year
Caveat: Section 409A does not apply to every deferred compensation arrangement. The determination of whether an arrangement is subject to Section 409A and whether one of the exceptions to 409A applies is quite complicated, and you should consult with your legal advisor in making this determination.