Summer Reading List: Agreements Containing Release-of-Claims Provisions May Require Section 409A Amendments Before Year-End

Section 409A of the Internal Revenue Code applies to employment, severance and other similar agreements that provide for post-termination severance or other compensation payments unless the agreement qualifies under one of a handful of limited exceptions. Many types of employment agreements (e.g., agreements that include “good reason” or other voluntary termination triggers for severance, agreements that provide for severance to be paid in installments, etc.) may not qualify for an exception and therefore must comply with Section 409A in form and operation.

Employment agreements commonly condition severance payments upon an employee’s execution of a release of claims. As described in more detail in our previous articles in 2010 and 2011, the IRS has indicated that the typical way these release provisions are drafted does not comply with Section 409A and that covered agreements affected by this problem that have been in existence since Dec. 31, 2010 must be amended before the end of 2012 in order to avoid significant tax problems for employees and employers.

The Release Issue

A significant focus of Section 409A is to limit employees’ and employers’ ability to manipulate the timing of payments under covered deferred-compensation arrangements. Many employment agreements provide that severance payments will be made, or commence, only after an employee’s execution of a release of claims in favor of the employer. In accordance with federal employment laws, employees are often provided a minimum period (e.g., 45 days) following termination of employment to consider a release before signing it, and a minimum period (e.g., seven days) following execution of a release in which to revoke it.

According to the IRS, a release provision, such as the one described above, violates Section 409A if it gives an employee an indirect election as to when to receive or start receiving severance payments under a covered agreement. In particular, the IRS is concerned that release provisions may in effect permit an employee to delay the payment or commencement of payment of severance benefits under a covered agreement until the calendar year following the year of termination, depending upon when he or she signs the release of claims.

Example: A severance agreement that is subject to Section 409A provides that an executive will receive a lump-sum severance payment within 15 days following his execution and nonrevocation of a release of claims. The employee has 45 days after the date of termination to consider the release before signing it and seven days to revoke the release after signing it. If the executive’s employment were to terminate on Dec. 1, he could choose to delay his severance payment by waiting to sign the release until January of the following year.

The Fix

In Notice 2010-6 and Notice 2010-80, the IRS provided employers guidance on how to fix the release issue. The fix will depend on the exact release provision found in the covered agreement, but the general approaches can be summarized as follows:

• Agreements providing for severance payments to be made within a specified period following termination of employment and that are conditioned on an employee signing and not revoking a release should be amended to either:
  • Provide for payment on the last day of the period; or
  • Provide that if the period spans two taxable years, the payment will automatically be made in the later of the two years, regardless of the year in which the release is signed.

• Agreements providing for severance payments to be made following an employee’s execution and nonrevocation of a release and that do not have a specified payment period should be amended to either:
  • Provide for payment either 60 days or 90 days following the date of termination;
  • Provide for payment during a specified period not exceeding 90 days following the termination date, except that if the period spans two taxable years, the payment will automatically be made in the later of the two years, regardless of when the release is signed.

Documentary Compliance Transition Period: The End is Near

For covered agreements existing on Dec. 31, 2010 with noncompliant release provisions, employers have been able to rely on a transition period under which no document or operational failure will be deemed to occur if either:

• Payments were completed by March 31, 2011; or
• For payments made after March 31, 2011, where the release provision consideration period spans two tax years, the payments are made in the later of the two years (or, if in the earlier of the two years, are treated as an “operational failure” and corrected under Section 409A’s operational correction program).

However, this transition rule will expire on Dec. 31, 2012, meaning that all covered agreements must be in documentary compliance with Section 409A’s release timing rules before the end of this year.

If a “bad” release provision in a covered employment agreement is not fixed before the end of this year, the agreement can thereafter be fixed only under the IRS’s document correction program, if eligible. Corrections under the document correction program are subject to additional requirements (including a filing with the IRS) and may protect employees from only a portion of the tax penalties that would otherwise apply.

Covered agreements entered into after Dec. 31, 2010 are not eligible for this transition relief and can be corrected only through the IRS’s Section 409A document correction program, if eligible.

Other Arrangements May Be Covered

It is important to note that it is not only employment and severance agreements that may be affected by this release timing issue. Certain other types of arrangements that are or may be covered by Section 409A, such as nonqualified retirement plans, may condition the payment of benefits upon the employee’s execution of a release of claims or other similar agreement. Such other arrangements would also need to be fixed to comply with the Section 409A release timing rules as well.

Three-Step Action Plan

Given the coming expiration of the transition period, employers should take the following steps to ensure any covered agreements with release provisions comply with Section 409A:

1. Identify all agreements that provide for payments contingent upon an employee executing a release of claims or other similar agreement.
2. Determine whether any of these agreements are subject to Section 409A.
3. Amend covered arrangements containing impermissible release provisions to comply with the release timing rules (and ensure that such amendments are adopted by Dec. 31, 2012 for any such arrangement that has been in existence since Dec. 31, 2010).

While these three steps may appear straightforward, there is a significant amount of nuance involved in determining whether employment and other types of agreements are subject to Section 409A and whether existing release requirements comply with the Section 409A timing rules.