In early 2010, the IRS surprised the benefits community by stating in Notice 2010-6 that deferred compensation arrangements that condition payment on employee action (such as the execution of a release, noncompetition agreement, or nonsolicitation agreement) violate the deferred compensation tax rules of Code Section 409A if the employee can accelerate or delay the year of payment. Notice 2010-6 provided a method for correcting the plan document and transitional relief through December 31, 2010. In response to numerous comments, the IRS extended the transitional relief period in Notice 2010-80 to December 31, 2012. Now is the time for employers to review severance and deferred compensation arrangements that are subject to Section 409A to determine if amendments are required by year end.
Severance agreements commonly grant employees a review period (e.g., 21 or 45 days) and a revocation period (e.g., 7 days). These time periods may allow employees to control the year in which they receive payment. For example, if an employee terminates employment on December 1 and the severance agreement contains a 45-day review period and a 7-day revocation period, the employee can control the year of payment by either executing the agreement before or after January 1. The IRS concluded in Notice 2010-6 that this violates Section 409A because the employee can effectively control the year of payment contrary to the requirement that an employee cannot designate the year of payment of deferred compensation.
This issue can arise when a deferred compensation arrangement conditions payment on an employee action. The most common scenario is a severance arrangement that conditions payment on the employee executing a release of claims in favor of the employer. The issue can also arise in the context of an offer letter, employment agreement, change-in-control agreement, nonqualified deferred compensation arrangement, noncompetition agreement, nonsolicitation agreement, or equity arrangement. Employers should carefully review all of their Section 409A deferred compensation arrangements to determine if any of the arrangements condition payment on an employee action.
Note that this issue not only applies to deferred compensation plans that are subject to Section 409A, but also if the deferred compensation arrangement is structured to fall within the short-term deferral or separation pay exceptions. For more information on Section 409A and links to the final regulations, see our prior guidance at www.perkinscoie.com/news.
Section 409A mandates specific documentation and operational requirements. All material terms of a Section 409A plan must be in writing, such as the amount deferred, the method for determining the deferral, and the time and form of payment. Failure to comply with such requirements can result in severe federal and state income tax consequences, including a 20% additional tax imposed on the employee.
For Section 409A plans that condition payment on employee action and defer income beyond December 31, 2012, Notice 2010-80 provides transitional relief (including relief from certain reporting requirements) for employers that amend the written plan document on or before December 31, 2012 to remove the ability of the employee to delay or accelerate the year of payment. The method of correction depends on whether the Section 409A plan provides for payment within a designated period of time.
If the plan provides for payment (subject to employee action) within a designated period of time following a permissible payment event, the amendment must provide either for:
payment only on the last day of such designated period, or
payment in the following taxable year if the designated period ends in the following taxable year.
If the plan does not provide for payment (subject to employee action) within a designated period of time following a permissible payment event, the amendment must provide either for:
payment only upon a fixed date either 60 or 90 days following the occurrence of the permissible payment event, or
payment during a specified period of time not longer than 90 days following the permissible payment event under the condition that if the specified period ends in the following taxable year, the payment will be made in the following taxable year.
The amendment may not otherwise change the time or form of payment, and the correction cannot be made after December 31, 2012 if the permissible payment event has already occurred.
The preceding relief applies to existing Section 409A plans that (1) continue to defer compensation after December 31, 2012 and (2) were in existence and eligible for correction under Notice 2010-6 on or before December 31, 2010. For payments of deferred compensation on or before December 31, 2012, Notice 2010-80 provides additional transitional relief.
After December 31, 2012, Notice 2010-6 (as amended by Notice 2010-80) provides that "a plan provision eligible for this section may be corrected in accordance with this section before the date an event occurs that would be a permissible payment event under Section 409A to which the provision applies." In other words, the correction is only available if the permissible payment event has not yet occurred.
Employees who commence participation in the deferred compensation arrangement after December 31, 2010 are eligible for the transitional relief if the terms of the arrangement are substantially similar to the terms as of December 31, 2010. Notice 2010-80 clarifies that the employer may amend the arrangement even though the employer previously amended the arrangement under Notice 2010-6 to address this issue. Notice 2010-80 provides a number of helpful examples and addresses reporting requirements.
Prior to December 31, 2012, employers should review all compensatory arrangements that condition separation pay on employee action and properly amend them as needed to correct any noncompliant provisions. In addition to traditional severance arrangements, employers should review offer letters, employment agreements, release agreements, change-in-control arrangements, nonqualified deferred compensation arrangements and equity arrangements not exempt from Section 409A.
Employers should consider whether any internal processes can be enhanced to promote document compliance with Section 409A. Such processes may include procedures to review drafts of new compensatory plans, agreements and other arrangements to ensure compliance with Section 409A. Employers should also consider training for those personnel responsible for negotiating compensatory arrangements. Such training could include a basic overview of the applicable documentation and operational requirements under Section 409A, with a goal of enabling personnel to spot issues and then properly address them.
Perkins Coie will be sponsoring a webinar on this topic. Details will be sent in the near future.
This Update provides only a general summary of Notice 2010-80. Click here to read the full text of Notice 2010-80.
You can also find additional discussions of Section 409A on our firm website.