United States: Hidden US Tax Issues In Signing A Release On Termination Of Employment

It is common in the US for an employer to obtain from a terminating employee a waiver and release of all claims (with certain statutory exceptions) against the employer. The consideration for the release is typically the payment of severance.

The customary form of release gives the employee 21 days (45 days if the termination is because of a group layoff), to consider the release, consult with counsel, if desired, and sign. Then there is a 7-day revocation period, after which the release becomes final and binding, and the employer pays, (or commences payment of), the severance.¹ The 21- or 45-day consideration period starts when the severance payments have been agreed upon and the final form of release has been presented.

Until 2010, there was little need to be concerned about the date the final form of release was presented to the employee for signature in relation to the date of termination of employment. That changed when the US Internal Revenue Service indicated² it would consider severance payments made after signing a release potentially to be "deferred" compensation, unless strict limitations set by the US Internal Revenue Code on the time and form of payment were both set forth in writing and observed in operation.³ These limitations require the terms of virtually all terminations that involve the signing of a release to be in writing if there is a potential for "deferred" compensation to be paid.

Under the US Internal Revenue Code, with certain exceptions, any amount of compensation, including severance, that is earned and/or vested in one year that could potentially be paid after March 15 of the subsequent year is "deferred" compensation.⁴ An employee may not electively defer compensation unless the election to defer is made prior to the year in which the compensation is earned. Severance is typically "earned" when a qualifying termination occurs. Thus, once the termination has occurred (or is imminent) it is too late to elect to "defer" compensation. There is a 20% excise tax plus interest penalties, all payable by the employee, for violating the rules on deferred compensation.

Under the applicable rules, payment of "deferred" compensation can only be triggered by a limited number of events. Termination of employment is one of those events.⁵ Signing of a release is not one of those events. Generally, a payment made on account of termination of employment will be deemed to have been made in compliance with the deferred compensation rules if it is made during the same year as the termination of employment, or within 90 days after termination, so long as the employee has no ability to affect the year in which payment is made.

However, in some circumstances, the employee could affect the year in which payment is made by delaying the signing of the release. Unless the release document prevents this in all circumstances, the employee will be subject to the excise tax and interest penalties even if, as the facts play out, severance is paid in the same year as termination of employment. This hidden tax issue can be illustrated by the following example:

Employee A is entitled to severance on termination of employment, provided Employee A executes and does not revoke a release. The document contains no time limit on when Employee A must sign the release. This violates the "deferred" compensation rules and will result in a 20% excise tax and interest penalties to Employee A, even if, as the facts play out, Employee A's employment terminates, and Employee A signs the release the same day, allows the revocation period to lapse, and receives payment immediately on lapse of the revocation period (i.e., all within the minimum possible amount of time). The problem is that the documents do not preclude a situation where Employee A could have a termination of employment in November or December, and by delaying signing the release, "elect" to have payment made in the subsequent year.

There are two alternative methods of avoiding the adverse tax result in the documentation of the employment termination arrangement:

• Provide for the severance payment to be made (or commence) "on the 60th day" following termination of employment, provided the release has been executed and the statutory revocation period has expired on or before the 60th day. If the release has not become irrevocable by then, the severance is forfeited. It is also permissible to provide for payment on a date less than 60 days from the termination date, but as a practical matter, in order to allow time for a 45-day consideration period and a 7-day revocation period to elapse, the document should not provide for payment before the 52nd day after termination of employment.

OR

• Provide for the severance payment to be made (or commence) within 90 days after termination, provided the release has been executed and the statutory revocation period has expired on or before the 90th day, and provided further, that if the 90-day period begins in one year and the revocation period could end in the subsequent year, the payment will be made in the second year.  

Incidentally, these timing rules apply not only to the signing of a release, but to any payment dependent on an employee action, such as executing a non-compete agreement.

Fortunately, the US Internal Revenue Service also permits faulty documents to be corrected by revising them to include one of the alternative methods of compliance at any time prior to the employee's termination of employment in order to avoid the excise tax and interest penalties.⁶  It's too late if the problem comes to light after termination of employment.

Footnotes

1. These time periods have become standard because they are required in order to satisfy the requirements of the 1998 regulations under the Federal Age Discrimination in Employment Act.

2. In IRS Notice 2010-6.

3. There are exceptions for severance payable by March 15 of the year after an involuntary termination of employment, and for other amounts payable solely upon involuntary termination of employment to the extent all of these criteria are met: (a) the amount is less than two times the prior year's compensation, (b) the amount is less than U.S. $520,000 (indexed after 2014), and (c) the amount is paid by the third December 31 after termination.  The termination must be truly involuntary or must be a resignation on account of a narrowly defined set of "good reasons."  Nevertheless, these exceptions cover many severance payments, even if a release is required.

4. Internal Revenue Code Section 409A; Treasury Regulation Section 1.409A-1(b)(4).

5. The other events are death, disability, a fixed date established prior to when the compensation is earned (such as age 65), a change in control of the company, and a documented severe financial hardship that cannot be satisfied by other means. Each of the terms termination of employment (separation from service), disability, change in control, and financial hardship have very specific regulatory definitions.

6. IRS Notice 2010-6, modified by IRS Notice 2010-80.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.