Employers with employment, severance or other compensation arrangements with their employees should be aware the IRS has taken the position agreements that provide for payments, such as severance payments, that will be made only after the employee has signed a release of claims against the company (or has signed a non-compete, non-solicitation or similar agreement) may violate the requirements of Section 409A of the Internal Revenue Code if the employee could potentially control the year of the payment based on when he or she signs and returns the release.
For example, assume an employee has an employment agreement that provides for a severance payment to be made within 90 days following his termination of employment, but not until he executes a release and it becomes irrevocable. In theory, if this 90-day period overlaps the end of a tax year, the employee could wait to furnish the release until the later year, deferring his payment and the taxation thereof. Alternatively, the employee could quickly furnish the release to accelerate the payment and its taxation to the earlier tax year. The IRS believes giving the employee even indirect control over the timing of the payment in this way could result in a violation of Section 409A.
Under a transition rule, however, compensation arrangements can be amended before the end of 2012 to correct this payment structure. Section 409A sets forth very specific requirements that apply to deferred compensation arrangements, and if these requirements are not satisfied the deferred compensation becomes taxable to the employee and subject to interest, penalties, and an additional 20% tax when the compensation is no longer subject to a substantial risk of forfeiture. Accordingly, those employers with employment, severance or similar types of compensation arrangements that condition a payment upon the signing of a release should have those arrangements reviewed and, if necessary, amended to avoid these adverse tax consequences.