Agreements Containing Release-of-Claims Provisions May Require Code Section 409A Amendments Before Year End
Section 409A of the Internal Revenue Code (the "Code") applies to agreements that provide for post-termination severance or other compensation payments that meet the definition of "deferred compensation", unless the agreement qualifies under one of a handful of exceptions (such as the "involuntary separation pay plan" exception). The penalties for failing to comply with Code Section 409A are severe, and include a 20% excise tax on the "service provider" (i.e., the employee).
The IRS has identified one way that employment and/or severance agreements are especially at risk of violating Code Section 409A and that is if severance payments are generally conditioned on the execution of a release. The IRS is concerned that since the consideration and revocation period described in a release could span two calendar years, an employee may have the ability to pick the calendar year in which the income will be paid (by either accelerating or delaying the signing of the release).
In Notice 2010-6, as modified by Notice 2010-80, the IRS announced a correction program for certain Code Section 409A failures. Among other topics, the IRS stated that an agreement that provides for the payment of severance only upon the execution of a release will satisfy Code Section 409A if it is structured in one of the following ways:
- Payment is made on a fixed date (60 or 90 days) following the event that gives rise to the payment (e.g., the employee's termination date); or
- Payment is made during a specified period of time (not to exceed 90 days following the event giving rise to the payment), and if the specified period can span two calendar years, payment must be made in the second calendar year.
Notice 2010-80 includes special transition relief for agreements in existence on or before December 31, 2010, that do not comply with the Code Section 409A release timing rules above. Such agreements must be amended no later than December 31, 2012 with respect to amounts payable after such date, and the employer is required to file a statement of correction with its corporate tax return. No Code Section 409A penalties will apply in connection with such correction.
Notices 2010-6 and 2010-80 also permit the correction of agreements that were not in existence as of December 31, 2010 and contain Code Section 409A release timing errors. In order to avoid Code Section 409A penalties that would otherwise apply, the agreement must be amended prior to the event giving rise to the payment (e.g., termination of employment). Additionally, all agreements between the company and any other employees that contain the same or similar Code Section 409A release timing errors must also be corrected. For such corrections to be effective, the employer is required to file a statement of correction with its corporate tax return and the employee is required to file a statement of correction with the employee's individual income tax return.
Employers should review their employment or severance agreements to determine if the agreements must be amended to comply with the release timing rules under Code Section 409A. If you have any questions about whether Code Section 409A applies to a particular employment or severance agreement, please contact Ed Hammond at (248) 988-1821 or email@example.com; Kristi Gauthier at (248) 988-5854, or firstname.lastname@example.org; or Stephanie Hicks at (248) 988-5893 or email@example.com.