Nonqualified deferred compensation plans and agreements often provide for payment upon separation from service subject to a requirement that the employee execute a general release of claims. The IRS has indicated that the release provisions in such agreements will result in a violation of Section 409A of the Internal Revenue Code (“Section 409A”) if the employee has the ability to determine the time of payment depending on when he signs and returns the release. For example, if an employee separates from service at the end of the year, he can delay signing the release until after January 1 to ensure payment in the second taxable year. Accordingly, it is important to carefully draft release provisions in agreements to avoid violating Section 409A (the consequences of which may include early recognition of income tax plus a 20% penalty tax). Generally, a compliant provision will provide for payments either (i) on a fixed date following separation from service or (ii) during a specified period following separation (not to exceed 90 days) as long as, if the payment period spans two taxable years, the payment will be made in the later of the two years (irrespective of the year in which the release is effective and irrevocable).
Amending Existing Provisions under IRS Correction Procedure by December 31, 2012
Notice 2010-80 provides for transitional relief through December 31, 2012 so it is important to review and revise any noncompliant provisions before year-end. The correction method depends on whether the existing release provision specifies a period for payment (i.e., payment within 90 days following separation from service) or does not specify a period (i.e., payment will be made upon execution of a release). The relief is applicable as long as correction is made prior to the separation from service and no later than December 31, 2012.
- Specified period for payment. The amendment must provide for payment on the last day of the designated period; or in the second taxable year if the designated period would span two taxable years.
- No specified period for payment. The amendment must provide either for payment only upon a fixed date either 60 or 90 days following separation from service; or during a specified period not longer than 90 days following separation, except that payment must be made in the later year if that period could span two taxable years.
Employers that correct agreements under this relief are exempted from the information statement and reporting requirements applicable to employees under Notice 2010-6, but are required to attach an information statement to the employer’s tax return.
It is important to keep the rules outlined above in mind when drafting release provisions in any new agreements or arrangements.