Employers should be aware that December 31, 2012, is the Internal Revenue Service's (IRS) deadline for correcting certain documentary violations under Internal Revenue Code Section 409A ("Section 409A"). Specifically, December 31 is the deadline for correcting violations arising in connection with severance payments, the receipt of which is conditioned upon the action of an employee (such as the employee's providing a general release of claims, or a noncompete or nonsolicitation agreement) prior to commencement of a severance payment. This contingent payment arrangement is often seen in employment agreements, severance agreements and severance plans.
The Section 409A violation occurs in such arrangements when the employee may control the timing of when he or she receives the severance payment through his or her ability to control the timing of execution of a general release of claims, or another agreement. This often occurs in employer plans or agreements that do not provide an explicit designated period for payment following the employee's termination date. The violation also occurs with plans or agreements that provide a designated period for payment, but which can result in the payment being pushed into a later year depending on when the employee signs the release or other required agreement.
For example, in Notice 2010-6, the IRS stated that the following language is in violation of Section 409A due to the possibility of the payment's being made in one of two tax years: "Employee's employment agreement provides that the amount is payable within 90 days of Employee's separation from service, but not until Employee executes and submits a release of claims." However, the IRS provides that this can be corrected by amending the agreement to require payment of the amount on a specific date following the employee's separation from service (for example, on the 90th day following the employee's separation from service, provided that the employee has executed and submitted a release of claims). This removes the possibility of the employee's dictating the tax year in which the amount is received.
IRS Notice 2010-80 provides that these violations may be corrected by December 31, 2012, by amending noncompliant payment arrangements as outlined below.
- If an arrangement does not provide for payment within a designated period, the arrangement may be amended to provide explicitly for either (a) payment only on a fixed date (for example, either 60 or 90 days after the termination of employment); or (b) payment during a specified period no longer than 90 days after the termination of employment, subject to the condition that if the specified period begins in one tax year and ends in a second tax year, the payment will be made in the second year.
- If an arrangement provides for payment within a designated period (such as the "within 90 days" language in the example above), but may be made in one of two tax years, this provision may be amended to provide either for (a) payment only on the last day of that designated period or (b) payment in the second tax year if in any event the designated period begins in a first tax year and ends in a second tax year.
These Section 409A rules related to payments that can be timed based on action of the employee (and the correction methods above) apply only to amounts that constitute "deferred compensation" for purposes of Section 409A. Therefore, if the amounts involved are exempt from Section 409A, such as for example, the short-term deferral exception or the separation pay exemption, then these rules are not applicable. However, it can be challenging to determine whether amounts under an arrangement are exempt from Section 409A. As a result, all such arrangements should be reviewed to ensure that the provisions are either exempt from Section 409A or compliant with the guidance outlined above.
It is worthwhile for employers to take action now. While IRS guidance permits these Section 409A violations to be corrected after December 31, 2012, the correction may be burdensome for the employer and the employee, and potentially costly for the employee. Correction after that date will not be limited to an amendment of the applicable document, but will also require the employer to file a statement of correction with its corporate tax return and the employee to file a statement of correction with his or her individual income tax return. The employee would be subject to the Section 409A tax and interest penalties on the amount deferred under this noncompliant arrangement if its provisions are triggered prior to being amended.