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Employers beware: revise employment agreements and severance agreements soon to avoid tax trap
November 11, 2010
Employment Law Alert
Author(s): David S. Foster

Employers have a very limited window of opportunity left to revise employment agreements and severance agreements so as to avoid tripping over the tax rules governing “deferred compensation,” a term with a surprisingly broad definition. You should act quickly to have such agreements reviewed and, if necessary, revised to meet the new requirements by December 31, 2010.

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Early this year, the Internal Revenue Service released guidance that offers employers the chance to correct deferred compensation arrangements that do not comply with the tax laws. The guidance contains a transition rule under which certain document language can be corrected by December 31, 2010, without paying any tax or penalty. See our Benefits Alert of February 8, 2010.

Many employers have reviewed and updated their formal nonqualified deferred compensation plans. However, fewer employers have reviewed their employment and severance agreements.

Section 409A

Section 409A is the provision in the tax law that calls for immediate taxation, and imposes a 20% penalty, on nonqualified deferred compensation arrangements that do not meet specific requirements. 

Section 409A defines deferred compensation as income earned in one year, but paid in the next. This can include bonuses, expense reimbursements, and severance payments.

Section 409A liability can be avoided by careful drafting. As an example, if a severance payment triggered by an involuntary separation from service is made by March 15 of the calendar year following the separation from service, then the payment is exempt from these rules. Similarly, Section 409A does not apply to payments triggered by an involuntary separation from service if (1) the payments do not exceed twice the lesser of base compensation or $245,000 (adjusted for inflation) and (2) the payments do not extend beyond the end of the second calendar year after separation from service. Payments triggered by a voluntary separation from service for good reason are treated the same, but only if the definition of good reason meets certain specified requirements.

If the definition of good reason does not do so, it  will negate the above two exceptions.

Notice 2010-6

Notice 2010-6 is the guidance issued earlier this year by the IRS. It provides an opportunity to correct many (but not all) items that are now documentary defects to avoid tax liability, some of which are quite archaic, or just plain odd, and which include:

  • defective definitions of change in control,
  • defective definitions of disability,
  • references to “as soon as practicable,”
  • references to “termination of employment” instead of “separation from service,”
  • failure to require a 6-month delay of certain payments to “specified employees” of a public corporation,
  • failure to include the required conditions on reimbursement of expenses, and
  • release provisions that do not properly limit the time for signing the release.

In Notice 2010-6, the IRS adopted a new position with respect to employment agreements that condition payment upon the employee’s execution of a release or other documents, which may also require changes to those agreements. See our Benefits Alert of March 16, 2010. It is very important to make sure that all employment agreements that condition payment upon the employee’s execution of a release or other document satisfy Section 409A or are exempt from Section 409A.

Another correction alternative

Regulations proposed in December 2008 would allow certain Section 409A documentary problems to be corrected prior to the calendar year in which the rights to deferred compensation vest. Accordingly, if rights have not yet vested, correction may be available even beyond the scope and time period permitted under Notice 2010-6.

What to do now

Notice 2010-6 and the proposed regulations provide valuable opportunities for companies that have not yet achieved full documentary compliance with Section 409A to do so with reduced—or even no—adverse tax consequences. Accordingly, employers should arrange for a prompt review of their employment agreements.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.