Many employment agreements, especially those for high-level executives, provide severance pay upon a change in control or a termination without cause, but only if the employee signs a release of claims. The IRS has noted that these types of agreements may cause problems under Section 409A of the Internal Revenue Code. In addition to highlighting the concern, the IRS also provided a Dec. 31, 2012 deadline for taking corrective steps. Failure to comply with Section 409A could subject employees to substantial tax penalties.
What is the issue with severance, employment releases and Section 409A?
As discussed in prior DWT advisories, Section 409A governs the deferral of compensation, and in particular restricts the discretionary ability of employees and employers to alter the year in which deferred compensation is paid. A violation of Section 409A punishes the employee by accelerating the taxation of the compensation, imposing an additional 20 percent penalty tax, and triggering potential interest charges (additional state taxes may also apply).
When drafting release agreements, employers typically aim to satisfy various employment laws that can indirectly give employees some discretion over the timing of payment. For example, when an employee is over 40 years old, the Age Discrimination in Employment Act requires that the employee be given at least 21 days to consider any release of claim for age discrimination; an employee may choose to sign the release prior to the expiration of the 21-day period, but the employee has the right to wait at least 21 days. As a result, if an employee is asked to sign a release near the end of a year, then the 21-day consideration period effectively enables the employee to choose, in his or her discretion, whether payment will occur in the current year or the following year. The following example illustrates the issue:
Assume an employee has the right to a lump sum severance payment equal to six months of salary if she is terminated without cause and if she signs a release of claims. If the employee is terminated on Dec. 20, without cause, then she could sign the release quickly and receive payment this year or, in the alternative, wait until after Dec. 31, which would delay payment until the next year.
The IRS has identified this scenario (and others like it) as a violation of Section 409A.
Correcting this 409A issue
Fortunately, in Notice 2010-80 the IRS provided that employers and employees could avoid any Section 409A penalties in these types of situations by making appropriate corrections on or before Dec. 31, 2012.
Note: Employers and employees may assume their agreements are problem-free because they were reviewed and revised in 2007 or 2008 to comply with final regulations under Section 409A. That is a faulty assumption. The IRS issued final Section 409A regulations in 2007, and then later developed its opinion about the potential problem with release agreements. In short, a review of agreements in connection with the 2007 final regulations may not have considered the later-identified problem with releases.
If Section 409A applies to a severance pay arrangement1, and the severance payments are not triggered on or before Dec. 31, 2012, the employer and employee can use either of the following two correction methods:
- If the agreement or plan does not specify a period during which payment may be made after termination of employment or the employee’s execution of the release, the document may be amended to require that either:
- Payment will be made on the 60th or 90th day after termination, provided that the release has been signed and become irrevocable prior to the payment date; or
- Payment will be made within a period of up to 90 days after termination, provided that (i) the release has been signed and become irrevocable prior to the payment date and (ii) if the period spans two calendar years, payment will be made in the second calendar year, regardless of when the release is signed.
- If the agreement or plan does specify a period during which payment may be made after termination of employment or the employee’s execution of the release, but the document enables the employee to affect the year in which the payment is made, the document may be amended to require that either:
- Payment will be made on the last day of the specified period; or
- If the specified period spans two calendar years, payment will be made in the second calendar year, regardless of when the release is signed.
Correction by means of a written contract or plan amendment that is adopted by Dec. 31, 2012 may be made without any obligation of the employer or employee to report the correction to the IRS. However, if the correction is made after 2012, both the employer and the employee must report the correction to the IRS in order to avoid Section 409A taxes and penalties
What about severance payments triggered before an agreement is corrected?
The IRS Notice also addresses what to do if an employment agreement provided for severance (contingent on signing a release of claims) and the payment of severance is triggered in 2012. If an agreement under that scenario did not otherwise comply with Section 409A, the parties may resolve the Section 409A concern by delaying the severance payment until 2013. Payments that have already been made in 2012 may be eligible for correction under a separate Section 409A correction procedure.
If you have any questions, please contact any of the Davis Wright Tremaine attorneys listed on this advisory or your usual contact.
1 Many severance arrangements are exempt from Section 409A, either as a “short term deferral” that is paid shortly after termination, or under the “involuntary separation pay” exception. Although Section 409A-exempt arrangements do not require correction, it is still best practices to specify a date of payment similar to one of the examples shown in Notice 2010-80. For example, an arrangement that provides for a lump sum payment of severance 60 days after termination, but only if the release is effective by that date, will prevent manipulation of the date of payment and ensure that it always complies with the short term deferral exception.