Employers with severance, change in control or other deferred compensation obligations that permit employees to determine the timing of the payment by deciding when to execute releases or other documents should determine whether those agreements or arrangements violate the Internal Revenue Code (the “Code”). If so, there is an opportunity to correct the problem, but it is important to act before the end of the year.

The Potential Tax Problem

Internal Revenue Code section 409A governs non-qualified deferred compensation arrangements, including many change in control, severance and employment arrangements (generally, “arrangements”). Failure to comply with section 409A results in negative tax consequences to employees covered by the arrangements.

Under many of these arrangements, payments are available only if the employee signs an additional agreement, often a release of claims or a noncompetition agreement. For example, some employment agreements provide for payment of severance after termination of employment, but only if the employee signs a separate release of claims. Depending on the wording of the employment agreement, payment might be scheduled on a date certain (such as 60 days after termination), while other agreements set payment based on when the employee chooses to sign the document.

In 2010, the IRS announced that some arrangements that schedule severance payments based on when the employee signs the document may violate section 409A. The IRS reasoned that an employee should not be able to choose the year in which payment would be made and therefore reduce taxes.

We note that this problem does not affect many arrangements. A severance arrangement will not be subject to challenge under section 409A if:

  • Severance is paid only upon involuntary separation from service or resignation due to “good reason” as defined by section 409A; and
  • The total amount of severance is less than the lower of (i) twice the employee’s annual compensation, or (ii) $500,000.

In addition, section 409A will continue to have no application to payments that are only briefly deferred (i.e., “short term deferral”).

The IRS will permit employers to amend potentially noncompliant arrangements in effect before January 1, 2011 by adopting a correction provision approved by the IRS. However, the amendment must be adopted by December 31, 2012.

What Employers Should Do

Employers can avoid section 409A problems due to these severance issues by taking the following steps before the end of the year for all arrangements that first came into effect in 2011 and 2012:

  1. Review each arrangement to determine whether it is subject to section 409A and, if so, whether its terms may create a concern under the IRS announcement.
  2. If there is any question whether the severance arrangement poses problems under section 409A, consult with employment or benefits counsel.
  3. If there is a concern under section 409A, prepare an amendment to the arrangement. The amendment would schedule severance payments on a fixed date or during a fixed period after termination of employment. Note that the amendment need not eliminate the usual requirement of a release of claims; it only would prevent the employee from having the opportunity to time the tax year of payment.
  4. If necessary, obtain written consent from affected employees.
  5. Include a statement of these steps as part of the employer’s 2012 income tax return.

If you would like assistance in determining whether any arrangements require amendments prior to December 31, 2012, please contact Scott Galloway (206.447.8919; gallj@foster.com) or Steve Peltin (206.447.6215; pelts@foster.com).