Section 409A is a section of the Internal Revenue Code that provides comprehensive rules that dictate how nonqualified deferred compensation is taxed.  Very simply, “deferred compensation” is defined as a portion of an employee’s compensation that is paid out at a date after which the income is actually earned.  Some common examples of deferred compensation include pensions, retirement plans, and stock options.  The primary benefit of most deferred compensation is that the recipient is able to defer payment of applicable taxes to the date, or dates when the income is actually received.

Why Should Employers Care?

One major concern for employers is that severance benefits are generally considered a form of deferred compensation subject to Section 409A, unless an exception or exemption applies.  Severance is generally money that an employee receives, in addition to regular pay, when he or she leaves employment at a company.  Employers offer severance for a variety of reasons, but most commonly in exchange for a non-compete agreement, a non-solicitation agreement, or a release to settle potential claims.  

Often, severance is paid out in a lump sum shortly after the employee’s departure.  However, in some cases, the employer and employee agree that severance will be paid in installments, over time.  There are a variety of reasons why an employer and employee might make such an agreement, including employer cash flow issues, to encourage the employee’s continued good behavior, or to manipulate the timing of the payment, thereby changing the time when taxes must be paid on the money.

So What’s the Issue?

The IRS says that the ability of an employee to manipulate the timing of the payment, and perhaps even the year in which the payment will be made, may violate Section 409A.  Generally, an agreement can violate Section 409A in one of two ways.  First, a non-qualified deferred compensation plan, including a severance agreement will violate Section 409A if it contains provisions that are inconsistent with the Section’s rules.  In other words, an employee can suffer tax ramifications simply because the document itself is not drafted properly.  Second, if an employer pays deferred compensation in such a way that violates Section 409A rules, Section 409A penalties can be applied. Therefore, Section 409A has been said to require both “documentary” and “operational” compliance.

A Section 409A violation could result in the employee owing full taxes on all deferred compensation as soon as the employee has a right to receive it, plus a 20% penalty tax, plus interest if compensation was deferred in a year before the year of the violation.

If severance pay is paid in installments that could be paid in years after the year of termination, the severance pay may be subject to Section 409A unless it meets one of the other exceptions.

What Is “the Fix”?

Employers must ensure that existing severance agreements comply with the requirements of Section 409A.  If the separation pay is subject to Section 409A, then it must meet the Section 409A payment timing requirements.  In its most basic form, this means that the agreement should provide for payments at a fixed time or on a fixed schedule, subject to the employee signing a release of claims, noncompetition, or non-solicitation agreement.  For example, requiring that the payment be made on the 60th or 90th day following termination of employment, or during a specified period of 90 days, or less.  Note that there are additional requirements if the payment period spans two years.

The IRS is allowing employers until the end of 2012 to fix any Section 409A offending language (in many cases, without penalty).  Therefore, before the end of this year employers should review and modify all severance agreements, employment agreements, change in control agreements, and nonqualified plans that provide for contingent, deferred payments.  Employers should review and revise all relevant documents that that provide for payments to be made anytime after March 31, 2011 to adopt permissible release language.

One more note of caution: Section 409A may also apply to severance paid to independent contractors.