In 2004, Section 409A was added to the Internal Revenue Code. Section 409A is designed to rigidly regulate nonqualified deferred compensation arrangements. In order to encourage compliance with Section 409A, Congress provided for a 20 percent excise tax (as well as other penalties) to be imposed on any individual who is the beneficiary of a noncompliant deferred compensation arrangement. In other words, if Section 409A is violated, the affected employee (and not the employer) is penalized.

Since the legislation was originally enacted in 2004, regulatory and other guidance has been issued in several installments. By now, most employer-employee arrangements that fall under the Section 409A umbrella have been amended at least one time to comply with the myriad of Section 409A rules. Before the end of 2012, however, all employers should review their employer-employee arrangements one more time for a very specific provision that could cause those arrangements to be noncompliant.

In 2010, the Internal Revenue Service (IRS) issued a correction program for Section 409A-related plans. In the correction program, the IRS stated that a very common provision in severance plans and employment agreements may cause those arrangements to fail to comply with Section 409A. Specifically, the IRS has stated that if a contractual payment is conditioned on the employee or former employee first executing a release of claims in favor of the employer, and if the time period during which the employee is allowed to consider and revoke the release spans two tax years, then the employee or former employee effectively has the ability to impermissibly defer receipt of the payment from one tax year to the next. In the correction program, the IRS provided that such impermissible provisions can be corrected or clarified without incurring a penalty, but the correction needs to be effected prior to the end of 2012.

Typical arrangements under which a release is required in order to obtain a payment include:

  • Offer letters that provide for severance payments
  • Employment agreements
  • Severance agreements
  • Severance plans
  • Certain bonus plans
  • Change in control agreements

The "correction" that needs to be implemented is relatively simple (by ensuring the employee does not have the ability to determine the year in which the payment will be made), but it needs to be completed and documented very soon. All employers should review their employee arrangements now, and employees also should ensure their agreements are compliant with the Section 409A release rules.