Severance and Other Deferred Compensation Arrangements That Condition Payment On Employee Actions May Need to Be Amended by December 31, 2012
As a general rule, Section 409A requires that distributions made under a covered arrangement be made upon the occurrence of one or more of the trigger events described in Section 409A(a)(2) (e.g., separation from service) and may be paid at a specified time or pursuant to a fixed schedule. A covered arrangement that provides for distribution of the entire benefit on the sixtieth day after separation from service, for example, complies with this timing requirement. An arrangement that provides for distribution within six months after separation from service does not. Likewise, a covered arrangement that conditions payment upon employee action, such as the execution of a release of claims, will not comply with the timing requirement, if the employee can affect the timing of payments by when he/she takes the required action (e.g. signs the release).
It is common for employers to condition payments under certain types of agreements, including employment agreements, severance agreements and plans, and change in control agreements, contingent on employee action. If an employee can affect the timing of payments by taking the required action sooner or later, the payment(s) probably will not satisfy the timing requirements of Code Section 409A, resulting in significant additional taxes. In Notice 2010-80, the IRS addressed this issue by providing transitional guidance for Section 409A compliance under such circumstances. Although the transitional guidance allows arrangements to comply with Section 409A without the need plan amendments for periods before Dec. 31, 2012, a non-compliant arrangement must be amended to comply with Section 409A by not later than Dec. 31, 2012.
An amendment will generally be required if the following conditions are met:
The arrangement is subject to Section 409A, and
Payments under the arrangement are contingent on employee action, and the employee can affect the timing of payments by the timing of his/her action.
Arrangements Subject to Section 409A
Section 409A applies to a very broad spectrum of arrangements, including many employment agreements that include separation benefits, severance plans or agreements, and change in control plans or agreements. There are two rather broad exceptions to Section 409A, which eliminate a large number of such agreements from its coverage, particularly if the arrangement does not cover highly compensated employees.
The first broad exception applies to short-term deferrals. Under that exception, Section 409A does not apply to any payment that is received within 2-½ months after the end of the employer's (or employee's) tax year in which the employee's interest in the payment is no longer subject to a substantial risk of forfeiture.
The second broad exemption is for certain payments due to involuntary separation from service or participation in certain window programs. Payments under such programs are generally exempt from Section 409A to the extent that the payment does not exceed two times the lesser of (i) the employee's annualized compensation based on his/her annual rate of pay; or (ii) the maximum amount of compensation that can be taken into account for qualified plan compensation under Code Section 401(a)(17) for the year of separation from service. In addition, the plan must provide that the severance pay will be paid not later than the last day of the employee's second tax year after separation from service.
The determination of whether an arrangement is subject to Section 409A and whether one of the exceptions to 409A applies is quite complicated, and you should consult with your legal advisor in making this determination.
Corrective Amendments Permitted under Notice 2010-80
Under Notice 2010-80, an arrangement that makes payments contingent on employee action that causes the timing rules of Section 409A to be violated can be corrected by any of the following amendments:
An amendment that removes the ability of the employee to delay or accelerate the timing of the payment as a result of the employee's action.
Example: A severance plan subject to Section 409A provides that an employee is entitled to severance benefits after separation from service, with payments to begin as soon as administratively feasible after the employee's release of claims becomes effective and to continue monthly thereafter for 30 months. The employee's release becomes effective eight days after he/she returns the executed release to the employer. Once the employer distributes the form of release to the employee, the employee has at least 21 days to execute it.
This above arrangement does not satisfy the distribution rules of Section 409A. To satisfy Section 409A, the arrangement could remove the requirement that the employee sign the release (which would not be satisfactory to most employers) or provide that payments will commence on the 60th day after the employee's separation from service, provided that the employee will not be entitled to any payments under the arrangement unless his/her release is effective on the 60th day after separation from service.
An amendment that provides for payment only upon a fixed date that is either 60 or 90 days after the triggering event (e.g., the 60th day following separation from service).
An amendment that provides for payment during a specified period not longer than 90 days following the occurrence of the trigger event under the condition that if the specified period begins in one taxable year and ends in a second taxable year, the payment will be made in the second taxable year.
Action Items to Be Completed by Dec. 31, 2012
We recommend considering the following actions with the assistance of legal or tax counsel:
Identify plans and arrangements subject to Code Section 409A;
Identify any such arrangements that condition payout on employee action that affects the timing of payments;
Amend the arrangement, if necessary, by Dec. 31, 2012.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.
Although the additional taxes are imposed in the employee, the employer is generally responsible for withholding the additional taxes.