Section 409A of the Internal Revenue Code (“Section 409A”) generally provides rules governing nonqualified deferred compensation arrangements with the main focus of such rules being limiting the ability of both the plan participant and his or her employer to manipulate the timing of payments under such nonqualified plans (although an employee/employer relationship is not required for Section 409A to apply). In order to accomplish this goal, Section 409A is extremely broad in scope and can also apply to employment agreements, change of control agreements, severance plans as well as other similar agreements that provide for severance or other compensatory payments unless the agreement qualifies under some limited exemptions from Section 409A.

Many employment agreements, change of control agreements, severance plans, and similar agreements (especially ones that pay severance amounts in installments, contain “good reason” resignation rights or contain unilateral walk-away rights following a change of control event triggering payment) may not qualify for an exemption and must comply with Section 409A. The typical exemption around which many post-termination severance arrangements are designed is the short-term deferral exemption (or STD exemption).  

In addition, a general employment release requirement is often included in employment agreements, change of control agreements, etc. as a pre-condition to the payment of severance benefits. When severance that is subject to Section 409A is conditioned on the execution of a release, it is imperative that the timing of the release comply with Section 409A. The IRS has indicated that many such release provisions do not comply with Section 409A and that certain agreements with problematic Section 409A release provisions must be amended by December 31, 2012 to avoid the risk that the arrangement violates Section 409A (the consequences of which may include early recognition of income tax plus a 20% penalty tax) or having to utilize a more formal and troublesome IRS correction procedure (although some agreements are already ineligible for this self-correction option).

The 409A release problem

Many general employment releases provide a period of either 21 or 45 days (depending upon whether it is an individual or group termination) during which the employee is allowed to consider the release and a seven-day revocation period during which the employee may revoke the release after it is signed. These time period requirements are mandated by federal law in order for such releases to be valid in waiving certain types of employment claims. While the 21- or 45-day consideration period is subject to waiver at the election of the employee, the seven day revocation period is not.

However, the IRS has taken the position that a release provision violates Section 409A if it gives an employee the ability to control the year in which severance payments will be made (essentially by making an indirect election due to the timing of the completion of the release and/or the waiver of the consideration period). For example, in certain factual contexts (such as late calendar year terminations) the employee could delay signing the release in order to move a lump sum severance payment (conditioned upon a valid release, but not satisfying the STD exemption) into a later tax year. This IRS position is especially problematic because it was not raised expressly by the IRS until years after Section 409A was enacted and was therefore not often addressed as part of routine Section 409A compliance efforts in the years spanning 2005-2009.

The potential 409A solution

Generally, a Section 409A-compliant provision will stipulate that payments will be made either (i) on a fixed date following the date of termination that is not movable based upon the date the release is signed (often 60 or 90 days following the date of termination conditioned upon an effective, irrevocable release being on file with the employer prior to the payment date) or (ii) during a specified period following termination with the proviso that, to the extent the permissible payment period spans two taxable years, the payment will be made in the later of the two years (irrespective of the year in which the release is effective and irrevocable) resulting in taxation in the second taxable year. However, the exact Section 409A solution (as well as permissible correction methods) will vary greatly on the specific facts and circumstances of the arrangement. As stated above, under IRS guidance non-compliant release provisions may be able to be amended to come into compliance provided that the amendment is adopted by December 31, 2012.

Other related items

It is important to realize that Section 409A release issues can also occur in the context of more traditional nonqualified plan arrangements. However, this generally occurs less frequently because these types of plans are clearly subject to Section 409A and most Section 409A compliance issues (like the release issue) have been addressed in such plans as part of ongoing Section 409A compliance efforts. The Section 409A danger for employment agreements, change of control agreements, severance plans and similar arrangements is that employers are not aware that Section 409A could even apply to such arrangements (and that a Section 409A violation could be found for something as minor as an incorrectly crafted release provision).

What to do now?

Employers should review their existing employment agreements, change of control agreements, severance plans and similar agreements to ensure that employees who may become entitled to benefits cannot control the timing of such payments due to a release requirement that does not comply with Section 409A. Section 409A and the IRS interpretations thereof continue to evolve and are not always intuitive. Unfortunately, the penalties for non-compliance with Section 409A can be large. Accordingly, you may want to discuss any potentially problematic release provisions discovered with a member of the Executive Compensation and Employee Benefits Group to see if correction is warranted by year-end. In addition, you should be mindful that Section 409A could apply to executive employment, change of control and severance arrangements that your organization implements in future. The members of the Executive Compensation and Employee Benefits Group are always available to review such arrangements to ensure Section 409A compliance.