Breaking up is hard to do.
— Neil Sedaka
Whether you are giving a departing employee a pat on the back or a kick in the backside on his way out the door, you probably want to get a release of claims without a whole lot of drama. For their part, most departing employees simply want their severance benefits and to move on with their lives. Historically, this release/severance dynamic has served both employers and employees well and kept countless claims out of our courts.
Then along came Section 409A of the Internal Revenue Code to upset this dynamic for unwary employers and make breaking up very hard to do (and costly, too). According to the IRS, severance benefits can be subject to the 20 percent tax penalty and other adverse tax consequences under Section 409A if they are contingent upon the execution of a release of claims and a departing employee can accelerate or delay the year of payment by when he submits the release.
For example, suppose an employee is terminated on November 30, 2012, and receives a release form subject to 45-day review and seven-day revocation periods. If he returns the form in the first two weeks of December, the employer’s payroll practices may dictate that severance will be paid in 2012. If he returns the form later, severance will be paid in 2013. Regardless of whether the employer or departing employee are even cognizant of this ability to accelerate or delay payment, the IRS’s position is that it results in adverse taxation under Section 409A.
In fact, any type of benefit that is contingent upon execution of a release — not just cash severance payments — is potentially subject to taxation under Section 409A. These benefits can be found in offer letters, employment agreements, severance plans, nonqualified deferred compensation arrangements and change in control agreements, among others.
With the exception of Uncle Sam, no one wants a departing employee to pay a 20 percent excise tax on separation pay benefits. Fortunately, the IRS has allowed employers to amend their written plans by December 31, 2012, to eliminate employees’ ability to manipulate the calendar year of benefit payments by the timing of releases. Typically, these simple amendments provide for the payment of benefits in the later taxable year.
Finally, note that the IRS did not reveal the full extent of its position (i.e., that this issue had the potential to become a priority focus on audit rather than an academic observation that Section 409A might apply) until the end of 2010. Consequently, plans, programs and arrangements that were most recently reviewed before 2011 may have problematic language even if they had previously been vetted for Section 409A compliance.