Section 409A, which was added to the Internal Revenue Code eight years ago, imposes potentially severe tax consequences on payments fitting within the broad definition of "deferred compensation" that do not comply with its requirements. The Treasury Department and IRS have released Section 409A regulations and guidance over the years, including some surprising interpretations of the rules. One of these twists involves the common practice where employment agreements, severance agreements and plans, and other types of nonqualified deferred compensation arrangements condition payment of deferred compensation on execution of a release of claims and/or a non-competition or non-solicitation agreement. For example, an employment agreement may provide that an employee's severance upon termination of employment is payable only after the employee executes a release of claims (and any revocation period has expired). The IRS has indicated that this type of provision may violate the requirements of Section 409A because the agreement gives the employee the control to delay execution of the release, thereby delaying the time of payment and manipulating the year in which the employee recognizes income tax.
Given the prevalence of these types of provisions in employment agreements, severance plans and other types of nonqualified deferred compensation arrangements, the IRS provided transition relief to correct these types of documentary failures in IRS Notice 2010-80. This transition relief is set to expire on December 31, 2012.
The transition relief set forth in IRS Notice 2010-80 generally gives employers until December 31, 2012 to amend eligible noncompliant nonqualified deferred compensation arrangements to comply with the Section 409A release requirements. However, the IRS Notice also provides that any payments made after March 31, 2011 that could be paid in a period that begins in one taxable year and ends in the subsequent year must be made in the subsequent year or corrected under the IRS's operational correction program (IRS Notice 2008-113).
Only arrangements that are subject to Section 409A are affected by these requirements. In addition, the type of correction method appropriate for a particular arrangement depends on the terms of the existing provision. For example, if an arrangement that conditions payment on an executed release already provides a designated period for payment (such as within a certain number of days following termination of employment), the arrangement must be amended to provide for either: (i) payment on the last day of the designated period or (ii) if the designated period could straddle two taxable years, payment in the second taxable year, regardless of when the release is signed and becomes effective. If an arrangement does not already provide for a designated period for payment, it must be amended to provide for payment as follows, regardless of when the release is signed and becomes effective: (i) upon a fixed date either 60 or 90 days following the separation from service or (ii) during a specified period not longer than 90 days following separation from service, provided payment is made in the second taxable year if the specified period could begin in one taxable year and end in the next taxable year.
For arrangements in existence prior to 2011 that are corrected by December 31, 2012, certain requirements normally applicable to Section 409A corrections will not apply. In particular, the employer is not required to provide information statements to employees about the correction and the employee is not required to make a tax filing with respect to the correction. The employer is required, however, to attach an information statement regarding the correction to its federal income tax return.
Employers should review all of their employment agreements, severance plans and other types of nonqualified deferred compensation arrangements that condition payment upon some action by the recipient such as the execution of a release of claims, a non-competition, non-solicitation and/or other agreement. To the extent such arrangements have not been amended to comply with the Section 409A release requirements, employers should amend these arrangements on or before December 31, 2012.