The payment of deferred compensation and severance is a tax minefield, courtesy of Section 409A of the Internal Revenue Code. Failure to meet the heavy regulatory requirements of Section 409A can trigger a punitive (and avoidable), immediate income tax plus interest and a 20% penalty tax on severance and other deferred compensation.

A common Section 409A tax trigger relates to the award of severance after an employee signs a release of claims, a non-competition agreement or non-solicitation agreement. The law grants an employee a period of time to decide whether or not to sign a release (or other promise) in exchange for severance. If the employee can delay or accelerate when severance will be paid by timing the execution of the release, Section 409A tax can be triggered on that individual.

Over the years, the IRS has issued guidance for correcting certain documentary violations of Section 409A to avoid that tax. Recently, taxpayers have been given an extended deadline for fixing Section 409A problems that relate to timing severance payments by timing the execution of the release.

Employers now have until December 31, 2012 to amend severance arrangements by adopting an amendment that meets one of the following requirements:

  • If the arrangement already provides that the severance will be paid within a certain time either 60 or 90 days after employment ends, the arrangement could be amended to provide that severance payments may begin only on the last day of a specified period.
  • If the specified period during which severance might be paid begins in one calendar year and ends in another, the payment must be made in the second calendar year.

If an employer misses the 2012 deadline for correction, it may still make the correction later, but must provide a notice to the employee which must be attached to his or her individual tax return for any year in which the individual is receiving payments under the corrected plan. If the plan provision being corrected spans two calendar years, the notice must be filed with the employee’s tax return for each year. Since many employers will want to avoid having an employee flag his or her return with such a notice, the preferable approach is to correct the release language by this year-end. Proposed regulations also give employers a chance to fix other failures involving unvested amounts without notices filed by employees.

Action Required

All non-qualified deferred compensation arrangements (typically found in employment contracts and severance agreements) that require a release of claims as a condition of payment, or a non-competition or non-solicitation agreement in exchange for severance, should be reviewed for compliance with Section 409A to avoid unnecessary taxation on the employee. Any required amendment should be put into place by December 31, 2012 to avoid this punitive tax.