The IRS has issued a notice under Section 409A of the Internal Revenue Code that requires review of agreements and plans that make compensation payments contingent on the recipient signing a release of claims or similar document.
Section 409A imposes substantial restrictions on nonqualified deferred compensation plans—defined broadly to include many employment contracts. Draconian penalties apply for noncompliance. Documents were required to be consistent with the requirements of Section 409A by January 1, 2009. The Internal Revenue Service recently released Notice 2010-6, which allows correction of certain documentary failures. Notice 2010-6 is discussed in our prior Benefits Alert.
In the notice, the IRS published for the first time a new restrictive interpretation of Section 409A relating to payments contingent on the execution by the employee (or independent contractor) of a document, such as a release of claims, a noncompetition agreement, or a nonsolicitation agreement. This new interpretation will require prompt revisions to many documents that were previously thought to comply with Section 409A. In most cases, revisions must be made by December 31, 2010, and before receipt of a notice of an IRS audit.
Under many employment agreements, severance agreements, and plans, payments become payable only when the employee executes a release of claims or other document. The IRS now takes the position that basing the commencement date for payments on the date the employee signs and returns a release or noncompetition agreement may enable the employee to control which taxable year payments may commence. This potential control by the employee over the timing of payments causes the agreement to violate Section 409A. For example, if an employment agreement conditions the commencement of severance benefits on an employee executing a release, and the employee has 45 days to execute and return the release, if the employee is terminated on December 1 the employee could push the commencement of his or her severance benefits until the next year by waiting until January to execute and return the release.
The IRS also takes the position that if payments under an agreement are conditioned upon the execution of a release or other document and there is no fixed time period for executing the document, the agreement violates Section 409A.
The notice provides the ability to correct an agreement that makes payment contingent upon the employee’s execution of a release or other document. As long as the agreement is corrected prior to the employee’s separation of service (or other payment event) and the employee and the employer each attach a disclosure statement to their tax returns, the draconian Section 409A penalties will not apply.
Not all severance or employee payment plans are subject to Section 409A. If all payments under an agreement are made by March 15 of the calendar year following the year in which the right to the payment vests, then the payment is considered a “short-term deferral” and exempt from Section 409A. For example, many separation agreements that are created at the time of separation with a prompt lump-sum payout may not present a problem.
Nonetheless, it is extremely important to review whether any employment agreement, severance agreement, or deferred compensation plan conditions payment upon the employee’s execution of a release or other document in a way that does not satisfy Section 409A.