December 31 is IRS deadline to correct Section 409A violation due to severance conditioned on release of claims
Many severance and other compensation arrangements provide for payment only if and when the employee signs a release of claims and the release has become irrevocable.
For a general release of claims to be valid under federal employment law, the employer may be required to give the employee a specified number of days to consider the release and then an additional period of time in which to revoke the release after signing it.
The IRS believes that a release contingency for payment of severance or other deferred compensation could violate Section 409A of the Internal Revenue Code if not drafted correctly.
The IRS has given employers until the end of this year to correct the release contingency language in arrangements subject to Section 409A.
Release contingency provisions as currently drafted may violate Section 409A resulting in tax penalties
The IRS clarified that it believes that a release contingency for payment of severance or other deferred compensation could violate Section 409A of the Internal Revenue Code if not drafted correctly. Section 409A governs taxation of deferred compensation and has strict rules that prohibit employees and other service providers from choosing the tax year of their compensation at the time the payment is to be made. The IRS believes that release contingencies could violate Section 409A because employees could manipulate when they are subject to tax on the severance or other payment by either returning the release right away or waiting until the next tax year.
A release contingency is very common in severance arrangements, and unless an exemption applies under Section 409A, severance is considered deferred compensation subject to Section 409A for employees of both privately held and publicly traded companies. Determining whether an exemption applies under Section 409A is often complex. Also, even if all of an employer’s severance arrangements, employment agreements and offer letters, and other compensation arrangements with release contingencies were already reviewed and amended to comply with Section 409A by the end of 2008 as required by the final 409A regulations, these arrangements should be reviewed again in light of the more recently clarified position of the IRS.
If an arrangement violates Section 409A, the result is income inclusion upon “vesting” – not payment – which results in a timing mismatch of the employer’s intended withholding obligations, and a federal 20 percent additional tax and interest penalty that applies to the individual service provider. States like California add similar penalties.
IRS permits favorable correction if completed before December 31, 2012
The IRS recognized that its position that release contingencies may violate Section 409A is relatively new. Therefore, the IRS has given employers until the end of this year to correct the release contingency language in arrangements subject to Section 409A and in existence on or before December 31, 2010. The correction guidance has some eligibility requirements that should be reviewed with counsel. If correction is permissible, all arrangements in the company’s controlled group that are subject to Section 409A and have a release contingency must be corrected. To correct a non-compliant release contingency provision: (1) an amendment that revises the release contingency provision must be executed by the parties, and (2) the company must attach a disclosure statement identifying the correction with its tax return.
These are two examples of release contingency language which, if the severance is non-exempt deferred compensation, does not comply with Section 409A:
Sample non-compliant provisions
Severance will be paid or begin to be paid only if you have signed a general release of claims and it has become irrevocable.
Severance will be paid or begin to be paid within 60 days after your separation from service with the company only if you have signed a general release of claims and it has become irrevocable before payment is scheduled to be made or begin.
Following are two examples showing how the release contingency samples above could be revised to comply with Section 409A:
Fixed date provision: Severance will be paid or begin to be paid on the 60th day after your separation from service with the company provided that you have signed a general release of claims and it has become irrevocable before such 60th day.
Straddle provision: Severance will be paid or begin to be paid within 60 days after your separation from service with the company provided that you have signed a general release of claims and it has become irrevocable before payment is made or begins; provided, however, that if the period during which you have discretion to execute or revoke the general release of claims straddles two calendar years, then the company will make the severance payments starting in the second of such years, regardless of which year you actually deliver the executed general release of claims to the company, subject to the release agreement first becoming effective. You may not, directly or indirectly, designate the calendar year of payment.
Although these are common examples, each arrangement is unique and should be reviewed with counsel.
What happens if payment is triggered this year under a non-compliant arrangement
If payment is triggered this year under a non-compliant arrangement that was in effect as of December 31, 2010, then, under a special transition rule, it is possible that no amendment or other correction is required. However, if the release consideration period in the agreement starts in 2012 and may end in 2013, then the severance must start or be paid in 2013. Payment in this case in 2012 will result in a Section 409A operational failure that has a separate formal correction procedure.
What happens if correction is not completed by December 31, 2012
If correction is not completed by December 31, 2012, or if a non-compliant arrangement was entered into on or after January 1, 2011,then correction must be completed by amendment before payment is triggered under a non-compliant arrangement (for example, before an individual is terminated triggering the right to severance). However, correction after December 31, 2012 requires that the company provide an information statement about the correction to the employee that the employee will need to attach to his or her personal tax return, in addition to the requirement that the company attach a statement to its own return.
If payment is made under a non-compliant arrangement that has not been corrected before the triggering event occurs, then the opportunity to correct is lost and the Section 409A income inclusion rules and tax penalties will apply.
For more information
This is only a general overview. For more information, you may review IRS Notice 2010-80 and Notice 2010-6 and contact any of DLA Piper's employee benefits and executive compensation lawyers.