Keywords: claims provisions, employment agreements, IRS Transition Relief
In 2010, the Internal Revenue Service (IRS) published Notice 2010-61 in which it indicated that certain types of common release provisions found in employment and other agreements violated Section 409A of the Internal Revenue Code (Code), which governs nonqualified deferred compensation plans and arrangements. Later in 2010, the IRS issued Notice 2010-80, which provides transition relief for agreements that contain a noncompliant release provision described in Notice 2010-6. Employers, employees and others who are parties to agreements with noncompliant release provisions described in Notice 2010-6 must amend these agreements no later than December 31, 2012 in order to take advantage of the transition relief provided in the IRS guidance.
Code Section 409A governs "deferred compensation" and imposes detailed and complex requirements on amounts that fall within its scope. These requirements generally regulate deferral elections and the timing and form in which amounts of deferred compensation will be paid.
Penalties for noncompliance are harsh and fall on the employee:2 employees who are entitled to receive amounts that constitute deferred compensation pursuant to a plan or arrangement that is noncompliant with Section 409A's rules face the prospect of immediate income inclusion of vested amounts payable under the agreement (even if, under the agreement, the amounts are not scheduled to be paid until years in the future), an additional federal income tax of 20 percent on the amounts that must be included in taxable income, and interest at the federal rate for underpayment of income taxes, plus 1 percent. There may also be additional state income taxes, penalties and interest.
Although the penalties fall on the employee, employers have a duty under the income tax laws to properly characterize Section 409A arrangements as compliant or noncompliant through Form W-2 and Form 1099 reporting. In addition, employers may have withholding and employment tax obligations and may be liable for substantial penalties if they fail to comply.
The transition relief provided by Notice 2010-80 allows noncompliant arrangements to be brought into compliance without penalty.
Noncompliant Release of Claims Provisions
Unfortunately, Section 409A defines deferred compensation quite broadly. So broadly, in fact, that many compensation arrangements not generally thought to provide for deferred compensation are nonetheless subject to Section 409A. These arrangements can include severance provisions in employment agreements as well as payments under change in control agreements, retention bonus agreements and noncompete agreements.
Under many of the arrangements mentioned above, the payment of deferred compensation is contingent upon the employee signing and not revoking a release of claims against the employer following the applicable distribution event. In the past, these arrangements typically provided that any payments that are contingent upon a release will be paid or commence once the release becomes effective without specifying a period of time during which the release must become effective. Another common past practice has been to provide the employee a specific period (such as 60 days) following the applicable distribution event during which the employee must sign the release and the release must become effective, with the payments promised in exchange for the release then becoming immediately payable following the date that such release becomes effective.
In Notice 2010-6, the IRS clarified that an arrangement (including a severance arrangement or employment agreement) that conditions payment of deferred compensation on the execution of a release of claims (or other employment-related agreements such as noncompetition or nonsolicitation agreements) will violate Section 409A if such agreement either:
- Does not designate a period of time that is equal to or less than a 90-day period following the applicable distribution event during which the release must become effective or the employee will forfeit his/her right to such compensation; or
- Does designate a period of time that is equal to or less than the 90-day period described above during which the release must become effective (or the employee forfeits his/her benefit), but does not include restrictions on the timing of payment within such period in the event such period straddles two calendar years.
In the IRS's view, these arrangements violate Section 409A because the employee can impermissibly control the timing of when the release will become effective (by controlling when the employee delivers the release), and, therefore, also control the timing of when the payment of deferred compensation will be made.
In order to be eligible for the transition relief provided by Notices 2010-6 and 2010-80, an agreement that contains either of the violations described above must be amended no later than December 31, 2012 for amounts that remain deferred after December 31, 2012, as follows:
- If the applicable agreement does not contain a designated period for payment following a permissible payment event, it must be amended:
- To provide for payment only upon a fixed date either 60 or 90 days following the occurrence of the permissible payment event; or
- To provide a designated period of not more than 90 days for payment following a permissible payment event, and if such period includes more than one calendar year, payment no earlier than the first day of the second calendar year.
- If the applicable agreement does contain a designated period for payment of not more than 90 days following a permissible payment event, but the employee's action could affect the taxable year of payment (e.g., where such payment period straddles two tax years), it must be amended:
- To provide for payment on the last day of the designated period; or
- To provide that, if such period includes more than one calendar year, payment will be in the second calendar year.
The transition relief also requires employers to include information regarding the corrections on their federal tax returns.
Not all employment agreements or other arrangements conditioning payments upon releases must be amended. Some need not be amended because the payments are not subject to Code Section 409A. For example, an employment agreement that provides for severance payable in a lump sum only upon an employee's involuntary termination of employment may be exempt from Code Section 409A. Other agreements may already contain a fully compliant release provision. Unfortunately, the Section 409A rules are complex. Applying the exceptions and concluding that a release provision is either exempt from Section 409A or that an agreement is Section 409A compliant should be approached with caution.
As noted above, the deadline to take advantage of the transition relief is December 31, 2012; amendments must be effective by that date. Employers and others for whom nomcompliant release provisions could be an issue under Code Section 409A should be mindful of the steps they need to take to complete the amendment process before this deadline. Some amendments to employment agreements or other agreements may require compensation or board approval. Companies with US taxpayers abroad may have to take local laws into consideration. While these amendments are for the employees' benefit, it may also be advisable to allow sufficient time for the employee to review them with counsel.
Originally published November 28, 2012
1. For more information, please see ourMay 3, 2010, Legal Update, "Interaction of US Internal Revenue Code Section 409A and Releases of Claims," available at http://www.mayerbrown.com/publications/Interaction-of-US-Internal-Revenue-Code-Section-409A-and-Releases-of-Claims-05-03-2010/.
2. Section 409A apples to deferred compensation arrangements of both employees and independent contractors. For ease of discussion, we will refer to arrangements with "employers" and "employees" but this discussion applies equally to arrangements between independent contractors and the entities for whom they are providing services.
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