If you regularly draft or review employment, change-in-control or severance agreements, you know it is a standard practice to condition payment of severance benefits or other compensation on the employee signing a general release of claims against the employer. What you may not realize is that conditioning benefits on the execution of a release may give rise to tax problems for the employer and the employee under Section 409A of the Internal Revenue Code.
Section 409A, enacted in 2004, regulates deferred compensation arrangements (other than tax-qualified plans, such as Section 401(k) plans). As taxpayers have lamented practically since its enactment, Section 409A has an extremely broad reach – covering many different types of compensation arrangements beyond traditional non-qualified deferred compensation programs and retirement plans, including certain types of individual employment agreements.
An employment or other similar agreement – such as a severance, retention or change-in-control agreement or plan (referred to collectively as “employment agreements” for purposes of this article) – may be subject to Section 409A in a variety of circumstances. For example, Section 409A may apply if the severance benefits could be payable on the employee’s voluntary termination of employment, or if the total amount of such benefits could exceed $490,000 or could be payable more than two years after the employee’s termination date.
Employment agreements covered by Section 409A (“covered employment agreements”) must contain certain terms relating to the time and form of severance payments (including, for public companies, a mandatory six-month payment delay for any payments to top officers), and must be administered in accordance with these terms. Covered employment agreements that fail to comply with Section 409A in form or in operation may subject the employees to a harsh 20% additional income tax penalty on the amount of severance payable under the agreement, plus an additional interest tax penalty. Employers may be adversely affected as well, if they fail to report and withhold taxes on the deferred compensation subject to the violation for the correct taxable year.
The Problem with Employee Release Provisions
One of Section 409A’s primary effects is to limit employees’ and employers’ exercise of discretion over the time at which deferred compensation may be paid after rights to that compensation have been established. Fixed payment events and times must be objectively specified in sufficient detail in advance and generally may not be altered once the arrangement has been established without meeting onerous additional requirements.
A covered employment agreement that provides for severance benefits on a permissible payment event (such as an employee’s termination of employment – or “separation from service,” using the Section 409A terminology) generally may permit payment on or at any time within 90 days following the date of the event. However, this standard only applies to the extent that the employee does not have a direct or indirect election as to the time of payment within this 90-day period.
Key Point: In the IRS’s view, a release condition in a covered employment agreement, or other deferred compensation arrangement subject to Section 409A, violates that section if the release condition gives the employee an indirect election as to when to receive severance payments, based on when the employee elects to sign and return the release.
To understand the IRS’s position, it is helpful to consider the terms of a typical employee release provision, under which severance payments are scheduled to be made after (such as the first payroll date after) the employee executes the release and any revocation period with respect to the release has expired. Often, to comply with federal age discrimination laws, employees will be given up to 45 days following their termination date to consider a release before signing it, and up to seven days following execution of the release in which to revoke it. Payment of severance benefits would normally not begin until the revocation period has expired. Thus, severance payments under the typical covered employment agreement may begin anywhere from seven to 52 days (or longer – often the employee may have more than 45 days to consider the release) after the employee’s termination date, depending on how quickly the employee is presented with and signs the release. An executive entitled to severance under this type of agreement who terminated employment in late November 2011 could choose to delay the timing of his or her severance payments by waiting to sign the release until January 2012, when his or her income could be subject to tax at a lower rate. In the IRS’s view, this exercise of choice over the taxable year of income inclusion for deferred compensation payments is the sort of perceived abuse that Section 409A was enacted to prevent.
Whether this policy rationale is convincing or not, the fact is that the IRS has made it clear in Notice 2010-6 that it views this type of release provision as non-compliant with Section 409A. In fact, anecdotal reports suggest that “non-compliant” employee release provisions are one of the most common enforcement issues raised in Section 409A audits to date – illustrating how common these provisions are, and how they have generally managed to fly under the Section 409A radar of employers so far.
- Before entering into any new employment agreement , it is imperative to determine whether the severance benefits payable under the agreement are or may be subject to Section 409A. If so, the release language must not provide the employee with an indirect election as to the timing of benefit payments. This will generally mean including a provision stating that if benefits could be paid in more than one taxable year depending on when the employee signs the release, the benefits will automatically be paid in the later year, regardless of when the employee signs the release. In the example above, the provision would require that, if the 52-day period extends into 2012, the benefits would not be paid until 2012 in all cases.
Existing employment agreements should be reviewed as soon as practicable to determine whether this issue needs to be addressed.
- Pre-2011 Agreements : Covered employment agreements that were entered into on or before December 31, 2010, should be identified for operational compliance purposes. As a general matter, if severance payments were made or began under such a covered employment agreement on or before March 31, 2011, the release conditions in such arrangements will be deemed to comply with Section 409A. For payments that are made or begin under such agreements after March 31, 2011 and on or before December 31, 2012, the release condition must comply in operation with Section 409A, but the agreement generally does not need to be amended. If a payment has been made or begun under such an agreement after March 31, 2011 that has not complied with the release requirements in operation, then the payments can be corrected under the IRS’s operational correction program. If payments under such agreements have not been made or begun by December 31, 2012, then the agreement may need to be amended under the IRS document corrections program. For further information about these transition rules for pre-2011 agreements, see our previous news item.
- Post-2010 Agreements : Covered employment agreements entered into after 2010 are not eligible for the transition relief described above and should be given priority. It may be necessary to amend such agreements under the IRS document correction program and, if so, it is crucial to adopt such amendments before any severance or other compensation payments are made.
Other Items to Note
Employee release provisions may crop up as a condition to payment in other types of nonqualified deferred compensation arrangements as well, such as supplemental retirement plans.
The need to avoid discretion over the timing of payments applies not just to employee releases, but also to other similar documents (such as an agreement not to compete) that an employee may be required to sign as a condition of receiving any severance payments.