Non-qualified deferred compensation arrangements that are not exempt from Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), should be reviewed to ensure compliance with Section 409A’s rules governing the timing of release of claims.
Under guidance from the Internal Revenue Service (the “IRS”), if a company has in place a nonqualified deferred compensation plan that is not exempt from Section 409A, and the plan conditions receipt of benefits on execution of a release of claims, the agreement may need to be amended by December 31, 2012 to ensure compliance with Section 409A.
Conditioning payment of deferred compensation upon execution of an agreement (such as a release of claims) by an employee may allow the employee to manipulate the timing of receipt of the deferred compensation. The most common example is an employee who is given a period of time to consider whether to execute a release of claims (generally 21 to 45 days). This period of time (commonly referred to as “release timing”) could span two calendar years if the termination occurs in December, thereby pushing the amount required to be included in income to the next calendar year. It is this potential for manipulation that the IRS sought to avoid in Notices 2010-6 and 2010-80.
Examples of Arrangements with Release Timing Issues
The following agreements are, or may be, subject to Section 409A and also may condition receipt of benefits upon execution of a release of claims;
—nonqualified deferred compensation plan (where the employee defers salary or the employer guarantees a rate of return on deferred amounts);
—employment agreements with severance provisions that contain a definition of constructive termination or a “good reason” definition; and
—severance agreements, separation agreements and change in control bonus plans. The type of severance agreements that may be subject to Section 409A are those that contain a good reason definition, provide for periodic payments of severance paid over time and agreements that provide for separation pay in excess of Section 409A’s prescribed limits (lesser of two times the employee’s annual salary or $500,000 (for 2012)).
Making the Release Requirement 409A Compliant
An agreement that provides for the payment of deferred compensation will satisfy Section 409A’s release requirements if structured in the following two ways:
(1) payment is made on a fixed date (60 or 90 days) following the event that gives rise to the payment; or
(2) payment is made during a specified period of time (not to exceed 90 days following the event giving rise to the payment), and if the specified period can span two calendar years, payment needs to be made in the second calendar year.
Relief for Non-Compliant Release Requirements
IRS Notices 2010-6 and 2010-80 provide transitional relief for release requirements that are not compliant with Section 409A, but the type of relief varies depending on when the agreement was entered into or amended, as set forth in the table below:
|Type of Document||Time Frame for Correction||General Procedure for Correction|
|Agreements entered into on or before December 31, 2010||Must be amended no later than December 31, 2012 with respect to amounts payable in 2013 or thereafter.||Employer must file a statement of correction to its tax return, but the employee does not need to file a statement of correction.|
|Agreements entered into after December 31, 2010,|
or amended after December 31, 2012
|No deadline, but must be amended prior to the event giving rise to the payment (such as an employee’s termination date).||Employer and employee must both file a statement of correction with its and his/her respective tax return.|
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