Employment, severance and change in control agreements often contain provisions requiring a service provider (employee) to provide a release of claims against the service recipient (employer) in order to receive a payment. In 2010, to the surprise of many practitioners, the IRS stated that this common practice potentially violates Internal Revenue Code Section 409A because it impermissibly gives the employee discretion over the timing of payment, based on when the employee delivers an executed release to the employer. (For more information on Code Section 409A, including a description of how arrangements can be exempt from or compliant with its provisions, please see our Question-and-Answer Guide to Code Section 409A.)
Example: Ed is terminated on December 15, 2012. Under his 2009 employment agreement, he is entitled to an $800,000 payment on separation from service (for whatever reason), payable in installments over a 12-month period. No payment will be made unless he timely executes a release. Because on these facts Ed has discretion over whether the payment stream will begin in 2012 or 2013, under IRS guidance, payments may not satisfy Code Section 409A.
For nonqualified deferred compensation arrangements subject to Code Section 409A and in existence as of December 31, 2010, employers may take advantage of certain transitional relief offered by the IRS if the arrangements are amended by December 31, 2012 to remove employee discretion with respect to the timing of a release. The correction generally requires hard-wiring when the payment will occur, without regard to when the employee executes the release. Although arrangements that are exempt from Code Section 409A are not required to address this issue, we nevertheless recommend reviewing all arrangements that have release provisions because the terms of a release may inadvertently trigger Code Section 409A .