Section 409A of the Internal Revenue Code casts a broad net, imposing payment timing rules on various deferred compensation arrangements that allow, for federal income tax purposes, deferral of income from a tax year in which an employee becomes conditionally entitled to income to a later tax year.
Documentary Pitfalls
The Internal Revenue Service ("IRS") has identified certain arrangements with provisions that potentially run afoul of Code Section 409A. The offending provisions are most often found in employment agreements, severance plans and separation agreements that condition a departing employee's entitlement to severance payments upon execution of a noncompetition agreement, non-solicitation agreement or a waiver releasing potential or existing claims against the employer (as applicable, the "contingency"). Severance payments are made by the employer following satisfaction of the contingency.
Often, documents satisfying the contingency must be executed by the departing employee within a stated period of time (for example, a 90-day window period) following separation. If the period of time during which the contingency may be satisfied crosses tax years, then in effect the employee may be afforded the opportunity to choose in which tax year the income will be recognized for federal income tax purposes - in violation of Code section 409A.
IRS Correction Guidance and Relief
A failure to comply with the requirements of Code Section 409A may result in draconian income tax consequences to the departing employee. In addition to the income tax otherwise due and owing on the severance payments (and possible late payment interest), Code Section 409A requires the employee to pay an additional 20% income tax on the payments.
The IRS has published guidance intended to provide employers and employees with relief from the adverse consequences of a failure to comply with the payment timing rules of Code Section 409A. To gain this relief, employers must amend their plans or agreements no later than December 31, 2012 to remove a departing employee's discretionary control over which tax year the severance payment is received.
In this regard, the IRS has provided certain approved amendment options. A plan or agreement that provides for a window period within which to satisfy a contingency may continue to provide that window, but must be amended to provide that if the window straddles two tax years, then either (i) the severance payments will be paid in the second tax year regardless of the tax year in which the contingency is satisfied; or (ii) the payments will be made at the close of the window period, regardless of when the contingency is satisfied. If a plan or agreement does not provide for a window period within which to satisfy the applicable contingency, the plan or agreement must be amended to provide a 60- or 90-day window period that is subject to the restriction described in either (i) or (ii) above.
The amendment to the plan or agreement must be adopted prior to the event which gives rise to the payment (e.g., date of termination in the case of a severance plan), and may not otherwise change the timing or form of payment.
An employer taking advantage of the correction program must provide to the IRS with its 2012 tax return a statement describing the correction and listing the employee(s) involved (including name, social security number and the dollar amount(s) involved).
What to Do Now
Employers should carefully review existing employment agreements, severance plans, separation agreements and any other agreements which could potentially give rise to contingency windows that cross tax years. For example, an employment agreement that includes a pre-negotiated severance package may potentially give rise to the issue, as may a change-in-control arrangement. When the issue has been identified in an agreement or plan, the employer should amend the agreement or plan in accordance with the IRS-approved amendment options described above. In some cases (e.g., a signed employment agreement), the employee's consent may be required to effectuate the applicable amendment.
If you have any questions concerning correction of documentary or operational deficiencies in deferred compensation arrangements, please contact Jim Karas, head of Riker Danzig's Employee Benefits and Executive Compensation Group
