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
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
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
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
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:
- Identify all agreements that provide for payments contingent upon an
employee executing a release of claims or other similar agreement.
- Determine whether any of these agreements are subject to Section 409A.
- 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.