[author, Laura R. Westfall, New York, +1 212 556 2263, firstname.lastname@example.org]
Employment, change in control, and severance agreements, as well as severance and deferred compensation plans, often condition payment upon the execution of a release or a noncompete or other employment-related condition. Any such provision that gives a former employee discretion over the timing of his or her payments violates Section 409A of the Internal Revenue Code of 1986, as amended ("Section 409A"), which governs nonqualified deferred compensation. Such provisions should be corrected before December 31, 2012 under available transition relief, in order to avoid the possible imposition of reporting requirements on employers, and tax and interest penalties on employees.
Conditional Payment Window Provisions
Section 409A imposes specific requirements on the timing of deferral elections and the designation of the time and form of payment of benefits paid under nonqualified deferred compensation plans and agreements, including salary and bonus deferral plans, supplemental executive retirement plans, certain stock option arrangements, stock appreciation right arrangements, and restricted stock unit plans (collectively, "NQDCPs"). NQDCPs often provide that benefit payments will be made within a specified period (e.g., 90 days) after an employee's termination, subject to the former employee's execution of a general release of claims or a noncompetition or nonsolicitation agreement prior to the expiration of the period (a "conditional payment window provision"). However, conditional payment window provisions violate Section 409A if the employee may choose his or her year of payment by delaying execution of the release, depending on when the termination occurs. Consider the following example:
Example: John Smith's employment agreement provides that he will receive a lump-sum severance payment within 60 days after his termination from employment, subject to his execution and nonrevocation of a general release of claims within 45 days after his termination, and his non-revocation of such release within 7 days after such execution. Mr. Smith is terminated effective Nov. 31, 2012. If Mr. Smith executes the release on Dec. 1, 2012, his employer may pay the severance benefit as early as Dec. 8, 2012; however, if Mr. Smith waits to execute the release until Dec. 26, 2012 or later, his employer will not be able to pay the severance benefit until Jan. 1, 2013, due to the 7-day release revocation period. Because Mr. Smith decides when to execute the general release of claims, he controls whether his severance will be paid in 2012 or 2013. This control violates Section 409A.
Although payments made pursuant to a conditional payment window provision may not be subject to Section 409A if an exemption exists, each such provision should be examined to determine whether a correction is necessary.
Correction Methods and Transition Relief Through December 31, 2012
IRS Notice 2010-6, as modified by Notice 2010-80, provides that a noncompliant conditional payment window provision may be corrected as follows:
If the provision designates a payment period of a set length, the provision must be amended to provide for payment to be made either (i) on the last day of such period or (ii) if the period spans two years, in the second year; or
If the provision does not designate a payment period, the provision must be amended to provide for payment to be made either (i) on the 60th or 90th day following the event giving rise to the payment (such as an employee's termination date) or (ii) during a specified period not longer than 90 days following the event giving rise to the payment, except that if such period spans two years, the payment will automatically be made in the second year.
The transition relief described above is only available until December 31, 2012 and is subject to certain operational conditions. Further, in order to rely on this transition relief, an employer must take commercially reasonable steps to identify and correct all noncompliant conditional payment window provisions in its NQDCPs. For example, an employer cannot rely on the transition relief to correct a noncompliant conditional payment window provision in one employment agreements, unless the employer also corrects the noncompliant provisions in all its employment agreements.)
Any noncompliant conditional payment window provision in a NQDCP that is not corrected by December 31, 2012 will be deemed to violate Section 409A unless it can be corrected under another correction procedure. Any compensation paid to an employee pursuant to such a noncompliant provision may be required to be included in the employee's income when vested (not at payment), and may be subject to a 20% federal tax penalty, plus an interest penalty (in addition to ordinary income tax). In addition, employers may be subject to reporting and withholding requirements with respect to such compensation. Further, any correction of a noncompliant provision possible after December 31, 2012 will be subject to additional requirements (such as certain IRS filings), and may only protect employees from a portion of the tax penalties that would otherwise apply.
Given that the correction deadline is fast-approaching, we encourage employers to work with their counsel to identify all affected NQDCPs that include conditional payment window provisions, determine whether such provisions are compliant with Section 409A, and amend any noncompliant provisions by December 31, 2012. Note that such amendments may require the employee's consent and/or approval by the Compensation Committee of the employer’s Board of Directors. As always, King & Spalding will be happy to assist you in this process and in answering any other questions you may have on Section 409A generally.