July 10, 2012
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.
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:
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:
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:
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.