It is standard practice that employment agreements condition payment of severance benefits or other separation compensation on the employee executing a general release of claims against the employer. However, unless structured properly, conditioning such benefits on the execution of a release may give rise to adverse tax consequences under Section 409A of the Internal Revenue Code of 1986, as amended (Section 409A). Arrangements that are not compliant with Section 409A need to be identified and revised before December 31, 2012.
Section 409A regulates many different types of compensation arrangements beyond traditional deferred compensation programs, including severance arrangements. Severance arrangements (often part of an employment agreement) covered by Section 409A must contain certain terms relating to the time and form of payment and must be administered in accordance with those terms. Employment agreements that fail to comply with Section 409A in form or in operation may subject the employee to an additional 20 percent income tax on the amounts payable under the agreement, plus an interest penalty. Employers may also be adversely affected if they fail to properly report and withhold taxes on the non-compliant payments.
In general, payments of deferred compensation are compliant with Section 409A if the amounts are required to be paid upon a specified payment date or certain events, including separation from service. Section 409A allows payments of deferred compensation to be treated as timely made if paid after the specified payment date or event and within the same calendar year (or if later, within two-and-a-half months following the specified payment date or event), so long as the individual is not permitted to designate the taxable year of payment.
The Internal Revenue Service (IRS) views a plan/agreement provision that provides for payment following execution of a release as problematic, if the release requirement could potentially allow the recipient to influence the year of payment through the timing of their delivery of the release.
To address these release timing issues, the IRS issued Notice 2010-80, which offers employers the opportunity to maintain Section 409A compliance by amending deficient plans/agreements that were in effect on or before December 31, 2010. Generally, Notice 2010-80 provides two ways to address this issue and eliminate the opportunity to affect payment timing by delivery of a release:
- if the arrangement contains a designated period following the applicable payment event (e.g., the employee’s termination of employment) during which the release must be delivered, the arrangement must be amended to provide that payment will be made either (i) on the last day of such designated period, or (ii) during such designated period, except that if such period spans two taxable years, payment will be made in the second taxable year; or
- if the arrangement does not contain a deadline for delivery of the release, the arrangement must be amended to provide that payment will be made (i) either 60 or 90 days after the occurrence of the applicable payment event, or (ii) during a designated period no longer than 90 days, except that if such period spans two taxable years, payment will be made in the second taxable year.
In addition, Notice 2010-80 requires that notice of such correction be given to the IRS in an attachment to the employer's tax return.
Severance, employment and other nonqualified deferred compensation agreements that are subject to Section 409A and require an employee to sign a release to receive payment, should be reviewed for compliance with these requirements. In order to avoid potential penalties and qualify for the transition relief offered under Notice 2010-80, affected deferred compensation arrangements with non-conforming release provisions are required to be amended no later than December 31, 2012.
Note that certain arrangements that are not subject to Section 409A are not affected by these requirements (e.g., arrangements that are paid upon vesting (“short-term deferrals”) and exempt separation pay arrangements (limited amounts that are payable only upon an involuntary termination of employment)).