Don’t Wait to Fix Deferred Compensation Failures

By HunterMaclean Attorneys

Published in Business in Savannah

IRS guidance extends the opportunity for employers to correct document failures which inadvertently violate Section 409A of the Internal Revenue Code.

Originally enacted in 2004 to curb deferred compensation income tax avoidance abuses, Section 409A reaches beyond traditional executive incentive compensation programs and impacts employment agreements, bonus programs, and severance policies. Violation of Section 409A can mean automatic taxation on the deferred compensation at issue, even if the employee has not yet received that compensation, and a 20% penalty.

Essentially, Section 409A regulates any arrangement that defers payment of compensation to a year later than the year in which it was earned. Section 409A applies even if the payment of compensation is conditioned on future performance of services or the compensation could otherwise be forfeited.

All types of arrangements which are awarded or negotiated in advance of the determined payment timeline may be subject to Section 409A. For example, employment agreements may be subject to 409A because some agreements contain a contractual right to severance pay, but the severance pay may not be paid until years later when the employment is terminated.

Section 409A limits the payment of deferred compensation to certain events, requires the form of payment (lump sum or installment) to be predetermined, and prohibits almost all changes to the time and form of payment. Under Section 409A deferred compensation may be distributed no earlier than upon one of the following events: separation from service; disability; death; a specified date or pursuant to a fixed schedule; corporate change in control; or an unforeseeable emergency. Each of these events must be defined precisely and must meet certain parameters as set forth in the regulations under Section 409A.

Because the statute covers so many arrangements and the regulations are quite complicated employers and employee benefits practitioners requested guidance and relief from the compliance burden. In response to these requests, in 2010 the IRS established a correction program for Section 409A document errors. This correction program permits a transition period to correct inadvertent Section 409A document violations and reduces or avoids the harsh tax consequences of the violation. Most document failures had to be corrected by the end of 2010 under the program, but some corrections are still possible.

Employment agreements often condition payment of deferred compensation (including severance payments) upon the return of an executed release of claims. Severance plans and policies often contain similar release provisions. In the past, release provisions sometimes did not require a return of the signed release within a specified timeframe. These provisions created uncertainty and flexibility for the timing of payments under the arrangement. In January 2010, the IRS published guidance clarifying that an open ended or flexible release provision violates Section 409A and placing specific restrictions on release provisions.

Employers who had not amended documents and some who had incorrectly amended agreements and policies suddenly faced Section 409A violations. To alleviate the harsh impact on a broad range of agreements and plans, the IRS published Notice 2010-80 late in 2010 extending the document correction program and providing an opportunity for employers to fix errors with release provisions as well as some other document errors.

To take advantage of the correction program, employers should act quickly. Employers should pay careful attention to the timing of payments made under impacted agreements during 2011, as payments made after March 31, 2011 must comply with the corrective guidance contained in Notice 2010-80. Further, any affected agreements that are outstanding or have any payments still due after December 31, 2012, must be amended to correct the improper provisions in accordance with Notice 2010-80 no later than December 31, 2012.

All employment agreements, severance policies and plans, and other arrangements that condition payments on return of a release should be reviewed for Section 409A compliance based on the most recent guidance from the IRS. Employers should not rely on the fact that the agreements were reviewed for Section 409A compliance shortly after Section 409A was passed. Take advantage of any corrective procedures still available under the IRS correction program before it is too late.