Code section 409A does not allow the payment timing of deferred compensation to be contingent upon the execution of a release (including execution of non-solicitation agreements and non-competes) because it gives the employee partial control over the payment timing. From the perspective of the IRS, the ability to delay signing the release during the 90-day period could allow the employee to effectively choose the year in which taxation occurs—in violation of Code section 409A. The IRS considers this a Code section 409A violation if it is supported by the written plan document, regardless of whether the situation actually occurs. The problematic language is often found in employment and severance agreements, but can also arise in traditional deferred compensation plans.
Existing arrangements that were in effect as of December 31, 2010 may be corrected if they are amended by December 31, 2012. In addition, if payments were made between March 31, 2011 and December 31, 2012 and could have been, but were not, paid in the later of two taxable years, the payments should be corrected as operational failures. Correction also requires an attachment to the employer's tax return detailing the correction.
REINHART COMMENT: If a plan fails to comply with the requirements of Code section 409A, that plan and all plans that are required to be aggregated with it for an individual, are subject to three consequences. First, the amounts are subject to an additional 20% income tax payable by the individual. Second, the amounts are subject to normal income taxes payable by the individual at the time the amounts are first no longer subject to a substantial risk of forfeiture (or upon the failure, if later). Third, the individual must pay a "premium interest tax" determined as the amount of interest at the IRS underpayment rate plus one percentage point on the underpayments that would have occurred had the deferred compensation been includible in income at the time the amounts were first no longer subject to a substantial risk of forfeiture (vested). It is important to note that in an employment situation, these consequences are primarily borne by the employee (although the plan sponsor will have certain reporting and withholding obligations).
To check for a potential problem, employers can look for payment timing language under a plan, employment agreement or severance arrangement that allows for payment to occur "within" 30, 60 or 90 days, and provisions that require execution of a release, noncompete, nonsolicitation, or any other contractual arrangement.