[authors: Stuart N. Alperin, Neil M. Leff, Regina Olshan, Erica Schohn, Joseph M. Yaffe, Michael R. Bergmann, Kristin M. Davis, Berit R. Freeman, Alessandra K. Murata, Timothy F. Nelson, David C. Olstein]
Although it may seem early to start preparing for the holiday season, employers should get a head start this year.
Important IRS transitional relief under Section 409A of the Internal Revenue Code for nonqualified deferred compensation plans (including employment agreements) that provide for payments contingent on the execution of a release of claims expires on December 31, 2012.
I. What Is the Problem?
Nonqualified deferred compensation plans (which can include employment agreements and severance plans) often condition payments to which an employee would otherwise be entitled upon a separation from service on the employee executing a release of claims. For example, an employment agreement might provide that an executive’s severance upon termination of employment is payable only after the executive executes a release of claims (and after any statutory revocation periods have lapsed).
The IRS has indicated that it views these types of provisions as violating the documentary requirements of Section 409A because, in its view, providing for payment following execution of a release effectively allows the employee to control the year of payment through the timing of delivery of the release. The IRS views this as a violation whether or not, in reality, the release execution period crosses calendar years.
Because of the prevalence of these types of release-conditioned payments, in Notice 2010-6 and Notice 2010-80, the IRS provided correction guidance and transition relief. This transition relief is about to expire.
The transition relief currently permits employers to amend any noncompliant nonqualified deferred compensation plan that was in effect as of December 31, 2010, to comply with the Section 409A release requirements, but only if the plan is amended no later than December 31, 2012 (and also provided that any payments made after March 31, 2011, that could be paid in a period that begins in one taxable year and ends in the subsequent year are either made in the subsequent year or corrected under the IRS’s operational correction program (Notice 2008-113)). Corrections pursuant to the transition relief are not subject to certain requirements that are normally applicable to corrections under Section 409A — the employer is not required to provide to employees information statements about the plan correction and the employee is not required to make a tax filing with respect to the correction, but the employer is required to attach an information statement regarding the plan correction to its federal income tax return. Plans that were not in effect on December 31, 2010, may be corrected in the same way if they are substantially similar to arrangements in effect on December 31, 2010.
A plan or agreement with a noncompliant release-based payment that is not corrected may cause the affected employee to be subject to current income inclusion, a 20 percent penalty tax and additional premium interest taxes. If a plan or agreement is corrected before termination of the employee’s employment, but is not eligible for transition relief, the affected employee will be required to attach to his or her federal income tax return a statement regarding the plan correction.
II. What Should Employers Do Now?
Employers should carefully review all their nonqualified deferred compensation plans — particularly employment agreements, severance plans or agreements, nonqualified retirement plans and equity plans (and applicable award agreements) — that condition payment upon the execution of a release of claims (or a non-competition agreement or other restrictive covenant agreement). Employers should amend these plans on or before December 31, 2012. Employers should amend their plans using one of the available documentation correction methods. Which of the available methods will be appropriate in a particular case will depend upon whether the existing release provision specifies a period for payment (e.g., within 90 days following separation from service subject to execution of a release) or does not specify a period for payment (e.g., payment will be made upon the execution of a release):
If the plan provides a specified period for payment, the correction must provide for either: (1) payment only on the last day of the specified period or (2) payment in the next taxable year, if the designated period begins in one taxable year and ends in the next taxable year.
If there is no specified period for payment, the correction must provide for either: (1) payment only on a fixed date either 60 or 90 days following the separation from service or (2) payment during a specified period not longer than 90 days following separation, except that payment must be made in the later year if that period could span two taxable years.