Employment Contracts and Severance Agreements Should be Reviewed and May Need to be Amended by December 31 to Comply with Section 409A

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Summary

Severance agreements and employment contracts with release of claims provisions may violate 409A of the Internal Revenue Code. Bad release provisions may be fixed, penalty-free, before December 31, 2012.

Most severance agreements provide for a review period (e.g., 21 or 45 days) and a revocation period (e.g., 7 days). Many employment contracts and other forms of deferred compensation condition payment on the execution of a release of claims, covenant not to compete or non-solicitation agreement. In 2010, the IRS issued a notice1 which provides that such a review and revocation period or the requirement of such execution may violate Code Section 409A because the employee can control the year in which payment is made. The IRS did, however, provide a method of correction2 which, if taken before the end of this year, will allow an employee to avoid adverse tax consequences.

The Problem

In employment or severance agreements subject to 409A where payment is triggered by a separation from service, payment must be made either on a fixed date or within a period not to exceed 90 days and the employee must not have the right to designate the year of payment.

Severance agreements under which employees have a review and revocation period may allow employees to control the year in which they receive payment. For example, if an employee terminates mid-December and has a 21-day review period and a 7-day revocation period, the employee could decide to sign the release in December or January of the next year. Similarly, if the severance agreement is offered in the context of a group reduction in force, which requires the execution of a release within 45 days of separation in order to receive payment, the employee could sign the release in one year or the next. An executive employment agreement that is negotiated up front might provide for payment following the execution of a release within 60 days of termination; again, the executive would have the ability to decide when to sign the release.

The Correction

The IRS provided a method for employers to correct agreements that run afoul of these rules. The employer must amend the agreements on or before December 31, 2012 to remove the ability of the employee to determine the year of payment. The method of correction depends on whether the agreement provides for payment within a designated period of time:

If the agreement provides for payment within a designated period of time following termination (e.g., within 60 days subject to the employee signing the release), the agreement must be amended to provide for either:

  • Payment on the last day of the designated period (e.g., 60th day following termination), or
  • Payment in the following year if the designated period ends in the following year (e.g., within 60 days following termination, but in all events payable in the second year).

If the agreement does not provide for payment within a designated period of time following termination, the agreement must be amended to provide either:

  • Payment on a fixed date either 60 or 90 days following a separation from service provided that the employee has executed the release; or
  • Payment during a period (not to exceed 90 days from the separation from service) with the condition that if the period ends in the following year, the payment will be made in the following year, regardless of when the release is executed.

Specific rules apply if payments were triggered between March 31, 2011 and December 31, 2012 that involve payment of penalties.

After December 31, 2012

Penalty-free (no dollar cost) correction will only be available if the payment event (e.g., termination) has not yet occurred and certain notification requirements are satisfied. Specifically, the employee must be provided notice of the correction and attach a statement to his or her tax return. There is no requirement for employer reporting under this correction.

Act Now

The time to act is now. To avoid the risk of potential penalties and avoid the need to comply with employee notification, employers should review all employment, change in control and severance agreements that condition payment on employee action, and amend them to correct faulty provisions.

Note

These provisions do not apply unless there is deferred compensation that is subject to 409A. If the agreement provides severance pay upon involuntary termination, the payment does not exceed two times the lesser of the employee’s annual compensation or Code Section 401(a)(17) limit ($250,000 in 2012), and payments are completed by the end of the second calendar year following the year in which the separation from service occurs, then Section 409A does not apply.

Please contact the authors with any questions regarding this development.

1. Notice 2010-6

2. Notice 2010-80