Section 409A of the Internal Revenue Code (the “Code”) governs deferred compensation arrangements and requires such arrangements to comply with very specific rules to avoid the imposition of additional taxes (at the rate of 20%), interest and penalties on the deferred compensation payable to covered employees and other service providers. With certain exceptions described briefly below, compensation arrangements providing for severance payments, such as severance agreements or policies, employment agreements and change in control agreements, are subject to Section 409A of the Code.
The IRS takes the position that the timing of the payment of Section 409A covered severance benefits based upon when the employee signs a release or other required agreement is a Section 409A violation. The IRS has issued guidance (Notice 2010-80) that provides transition relief by permitting employers to correct certain documents that condition payment upon employee action, such as execution of a release or other agreement by the employee and the timing of the payment is based on the date the employee executes the release or other agreement, provided the correction is made no later than Dec. 31, 2012.
If severance benefits are treated as deferred compensation for Section 409A purposes, there are two alternatives for correcting impermissible provisions relating to severance benefits and releases under Notice 2010-80. In each case below, it is assumed that the required employee action (execution of a release or other agreement) has been completed prior to the payment and, if applicable, the revocation period has expired.
- The severance will be paid (or installment payments will commence) on a fixed date, either 60 or 90 days after the occurrence of the event triggering payment (e.g., separation from service) without regard to when the release or other agreement is executed; or
- The severance will be paid (or installment payments will commence) during a period not longer than 90 days after the occurrence of the event triggering payment, provided that if the specified period begins in one taxable year and ends in a second taxable year, the payment will always be made in the second taxable year.
For example, a compliant employment agreement might provide language similar to the following: Severance payments shall be conditioned upon the execution, non-revocation and delivery of a release agreement substantially in the form attached to this agreement by the employee within 60 days of the date the employee separates from the service of the employer. The severance payments shall be made (or shall commence) to the employee on the 60th day following the employee’s separation from service, provided the company has received a properly executed release by the employee during the 60-day period and the revocation period during which the employee is entitled to revoke such release has expired on or prior to the 60th day following the employee’s separation from service. If the employee fails to properly execute and deliver the release (or the revocation period has not expired during the 60-day period following the employee’s separation from service), the employee agrees that he shall not be entitled to receive the severance payments.
Alternatively, the provision above could provide that the severance payments will be made (or, if applicable, will commence) within 90 days following employee’s separation from service as determined by the company, provided the employee executes the release and the revocation period expires during the period and if the 90-day period spans two calendar years, payment must be made in all cases in the second calendar year regardless of when the employee executes the release.
There are two general exemptions for severance arrangements under Section 409A of the Code. One exemption applies to arrangements under which the severance is required to be paid on or before March 15 of the calendar year immediately following the calendar year in which the employee’s right to the severance payment ceases to be subject to a substantial risk of forfeiture (generally referred to as the short-term deferral rule). In general, a severance payment will be subject to a substantial risk of forfeiture until an employee’s termination of employment if the agreement provides that payment will be made only if the employee is terminated involuntarily by the employer without cause (or for certain “good reason” terminations by the employee). The other exception generally applies to arrangements under which severance is only payable on account of the employee’s involuntary termination (and certain “good reason” terminations), the severance will be paid no later than the last day of the second calendar year following the calendar year in which the employee’s termination occurs and the severance amount does not exceed two times the lesser of the employee’s current annual compensation or an amount described in the Code that is indexed annually ($250,000 for 2012). If one of these exceptions applies, the arrangement likely would not have to be amended to comply with IRS Notice 2010-80.
If an employer intends to rely on the special transition relief offered under IRS Notice 2010-80, the employer must take reasonable efforts to identify all deferred compensation arrangements subject to Section 409A of the Code that provide for payment of compensation contingent on employee action and correct such arrangements by amending the governing documents to include one of the two alternative payment provisions described above by Dec. 31, 2012. In addition, IRS notice 2010-80 requires the employer to notify the IRS of all corrections made by attaching a statement to its federal income tax return for its tax year in which the correction is made (the affected employees are not required to provide notice to the IRS regarding the correction of their compensation arrangements if the corrections are made by Dec. 31, 2012).
Compliance with the Section 409A rules not only avoids additional taxes, interest and penalties on the employee (or other service provider), but also permits the recipient of the compensation payment to defer the taxation of the payment to the date or dates on which the compensation is paid (rather than the date on which the recipient’s right to the compensation becomes vested).
Employers should review all deferred compensation arrangements, especially employment agreements, severance agreements, and change-in-control agreements that require employees to execute a release of claims, non-compete agreement, or non-solicitation agreement, determine if the agreements are subject to Section 409A of the Code, and amend the agreements as needed in a manner consistent with IRS Notice 2010-80 to eliminate any issues with respect to the compensation timing relating to the employees’ actions, such as the timing of the execution of a release.