Agreements that require a release or other signed document from an employee before payment should be reviewed to ensure compliance with Code Section 409A guidance.  Transition relief ends on December 31, 2012, and the penalties for noncompliance can be harsh.  Employers that conducted a fulsome Code Section 409A review in 2007 and 2008 should ensure their arrangements are in compliance with new guidance.


In 2010 the Internal Revenue Service (IRS) announced a correction program under Section 409A of the Internal Revenue Code of 1986, as amended (the Code).  As described in our 2010 White Paper, certain changes can be made without triggering penalties (see “New IRS Notice Provides Employers with Ability to Correct Defects in Nonqualified Plan Documents” for more information).  The program’s deadline was extended and employers have until December 31, 2012, to make corrections.  The following Questions and Answers address what corrections are required. 

What arrangements need to be reviewed?

Any arrangement providing payments that are conditioned upon an employment-related action of the employee (such as the execution of a release or restrictive covenants) must be revised to remove the ability of the employee to delay or accelerate the timing of the payment. 

Severance payments typically require an employee to sign a release of all claims against the employer, and no payments are made until the employer receives an executed release.  Some employers require an executed release before an employee can receive long-term incentive or other payments. 

The IRS has been concerned that the employee’s ability to decide when the executed release will be returned to the employer may provide the employee with the ability to control when the payment will be made.  This control, in the IRS’s view, could violate Code Section 409A in certain circumstances. 

What changes need to be made?

If an arrangement provides for payment within a designated period following the employee’s separation from service, and the payment is conditioned on the employee delivering and not revoking a release, the amendment must provide for payment only on the last day of such designated period.  Note: If the payment is not conditioned on a release or delivery of another document (e.g., restrictive covenant agreement), then no revisions need to be made for IRS Notice 2010-6 and IRS Notice 2010-80.

Example: An employment agreement provides that an employee will receive salary continuation for a period of 36 months following the employee’s separation from service.  The payments will begin within 45 days of the separation if the employee executes an enforceable release by such date.  The arrangement must be revised to provide that the first payment will be made no earlier than 45 days following the employee’s separation from service, even if the employee provides an executed release in advance of the 45 day deadline.

If the arrangement does not provide for payment within a designated period, the amendment must provide for payment:

  1. Only upon a fixed date, either 60 or 90 days after the occurrence of the permissible payment event (e.g., separation from service) 
  2. During a specified period not longer than 90 days after the occurrence of the permissible payment event (e.g., separation from service), provided that if the specified period begins in one taxable year and ends in a second taxable year, the payment will be made in the second taxable year

Example: An employment agreement provides that the employee is entitled to severance payments, but only if the employee executes a release.  The agreement does not provide a payment date for when severance payments commence. 

The employment agreement needs to be revised to provide that either the payments will be made (or begin) on the 60th or 90th day following the employee’s separation from service, assuming the release condition is satisfied, or the payments will be made within a period no greater than 90 days following the separation from service, except that if the 90-day period begins in one taxable year and ends in another taxable year then the payments must not commence until the second taxable year.

Under the latter example, assume that an employment termination occurs on December 1, 2012, and the employment agreement provides that severance payments commence within 90 days of the severance if the employee provides an enforceable release.  January 1, 2013, is the earliest date that severance payments can possibly begin under this example, as the 90-day period straddles two tax years.  The amendment should also address whether the delayed payments will be “bunched” and paid together at the earliest date possible, or whether the delay affects the entire revenue stream (e.g., the delay affects the first and all payments thereafter).

We already updated our documents for Code Section 409A.  Do we need to review our documents again?

Yes.  These additional rules were not included in the final regulations under Code Section 409A.  Unfortunately, the IRS’s concerns about releases running afoul of Code Section 409A were not announced until 2010, several years after employers had completed their extensive review for Code Section 409A. 

The IRS issued guidance in 2008 (Notice 2008-113) and 2010 (Notice 2010-6 and Notice 2010-80) that offered limited correction programs to address Code Section 409A compliance issues.  In the 2010 guidance, the IRS stated for the first time that a Code Section 409A violation could be triggered when an employee is required to return a release or other document before receiving a payment. 

The IRS’s position in 2010 that a release requirement could raise Code Section 409A concerns was a surprise.  Many employers that completed their Code Section 409A compliance reviews may not have taken this additional guidance into account. 

Our employment agreements and severance templates provide for lump-sum payments.  Do we need to review our documents again?

Yes.  Employers should confirm that the payment structure fits within the short-term deferral rule.  In short, the arrangement should provide that no payments can be made more than two and one half months following the tax year in which the separation from service may occur. 

Depending on the time of year of the employee’s termination and time consumed by negotiating the terms of an employee’s exit and the terms of the release, it is possible that an arrangement could inadvertently violate Code Section 409A if payments were made outside of the short-term deferral period.  In the course of negotiations, severance entitlements may also be revised in a way that violates Code Section 409A’s substitution rules.  We highly recommend that all severance arrangements be revised to specify the applicable payment dates to ensure compliance with Section 409A or the short-term deferral exception and limit the ability to make revisions to the severance arrangement that could violate Code Section 409A’s substitution rules.

Will the December 31, 2012, deadline be extended?

We do not anticipate that the deadline will be extended. 

Do we need to notify the IRS that amendments have been made?

Yes.  Employers taking advantage of the correction program will be required to provide notice to the IRS of the changes made.  The employer’s notice is attached to its federal tax return for the year in which the correction is made and includes:

  • The name and taxpayer identification number for each affected employee or service provider
  • Identification of the affected plan or arrangement
  • A statement identifying the IRS notice that provides the basis for correction, including the relevant section cite from the notice 
  • The date of correction
  • The amount involved in each correction

No employee notice is required if the arrangement is timely corrected. 

What other steps should employers take?

In light of Code Section 409A’s draconian penalties (including a 20 percent excise tax), it is important for employers to centralize their review and tracking of employment agreements, severance arrangements and change in control agreements to ensure that an employee cannot control the payment dates.  Employment agreements and severance arrangements are sometimes prepared without legal or tax review, which can make it challenging to identify these documents and ensure compliance with Code Section 409A.  Establishing a centralized system to track these documents can help meet these challenges. 

*      *      *      *    

It is important to engage in a review as soon as possible.  It may take several months to allow for internal review, legal review, employee communications, time for employees to consider the changes (if the arrangement requires employee consent to any changes) and time to finalize any amendments.  All of these steps need to occur before December 31, 2012.