Any arrangement that requires an employee to execute and deliver a release (or take some other action) as a condition to receiving severance or another deferred compensation payment should be promptly reviewed and, if necessary, amended for compliance with Section 409A of the Internal Revenue Code (“Section 409A”). The review of such arrangements should be done even if the operative instruments were previously amended for compliance with Section 409A. Since the enactment of the American Jobs Creation Act of 2004, which created the statutory provision, the IRS has issued multiple guidance and continues to identify issues that were previously not considered by practitioners to fall within the purview of the rules.
Section 409A requires that nonqualified deferred compensation plans comply with certain distribution election and timing of payment requirements, the violation of which results in the deferred compensation for the current and preceding years being immediately taxable and subject to a 20 percent penalty payable by the participant. The IRS has indicated that the interaction of release agreements and deferred compensation payments could run afoul of the rules thereby resulting in the adverse tax consequences.
The IRS noted that if an employee could have the opportunity to manipulate the timing of a deferred compensation payment through the employee’s actions (e.g., by timing the execution of a release agreement), then that arrangement could violate Section 409A. The foregoing scenario is problematic because the employee could effectively shift the time of payment from one calendar year to another, which violates the Section 409A rules that prohibit the participant from delaying the time of distribution unless certain rigorous requirements are met. One common example is an employment agreement with a severance provision that conditions payment on the execution by the employee of a release. Assume there is an employment agreement which (1) is subject to Section 409A, (2) provides for a lump sum severance payment equal to 12 months of base salary, and (3) provides for payment within 60 days after the execution and delivery by the employee of a release. The IRS will conclude that the employee can effectively control which year the severance payment will be made by controlling the timing of the execution and delivery of the release and, therefore, this agreement does not comply with Section 409A. There are ways to amend such an agreement to comply with Section 409A. To take advantage of special relief offered by the IRS under IRS Notice 2010 6 and IRS Notice 2010 80 and to avoid the tax penalties of Section 409A, however, action needs to be taken by Dec. 31, 2012.