The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Here’s a year-end action item from this Wilson Sonsini memo:

Severance and other compensation arrangements that promise a payment only if a release of claims (or other employment-related obligations, such as non-solicitation or non-competition agreements) is signed should be reviewed by December 31, 2012, for compliance with Section 409A of the Internal Revenue Code.1 Failure to ensure that these documents are in compliance could result in substantial penalty taxes and administrative burdens in the future.

Arrangements Most Likely to Be Affected:

– Severance plans and agreements
– Change-in-control and employment agreements
– Certain restricted stock unit and other cash-settled equity compensation awards that contain a severance feature

Background

Section 409A generally prohibits employees from manipulating the acceleration or delay of compensation. The Internal Revenue Service (IRS) issued guidance in 2010 addressing the concern that a compensation arrangement that requires the execution of a release of claims may allow an employee to manipulate the year in which the payment is made by accelerating or delaying the employee’s execution and delivery of the release of claims.2 To prevent this, the IRS set forth timing rules specifying when a release of claims must be executed to prevent a Section 409A violation. Interestingly, the final Section 409A regulations issued in 2007 do not state this IRS position. Therefore, some change-in-control and severance agreements that were drafted to comply with the final Section 409A regulations may not account for this later-released IRS position.

Moreover, since 2009, the IRS has employed a Section 409A audit program, and a targeted area of noncompliance includes agreements conditioning payment on a release of claims. Accordingly, we recommend that employers review agreements that condition severance and other compensation on the signing of a release of claims.

Release Timing Rules

If an arrangement does not contain a compliant specified period for executing a release of claims, the employer must amend it to provide that payment will be provided or otherwise begin:

– on a fixed date either 60 or 90 days following the employment-related event that gave rise to the payment (e.g., termination of employment), or
– during a specified period no longer than 90 days following the employment-related event.

Payment must be made in the later year if the specified period could span two taxable years.
If a compensation arrangement contains a specified period for payment, the arrangement must be amended to provide that payment will be made on the last day of the period, or in the second taxable year if the designated period can begin in one year and end in the following year.

Compliance Deadlines

Compensation arrangements that condition compensation on executing a release of claims should be amended by December 31, 2012, to comply with the release timing rules described above. In addition, an employer may be required to file a statement of correction with the IRS and to correct all agreements containing improper release timing. Depending on the facts, however, an employer or a service provider under IRS examination may not be able to correct its noncompliant arrangements.

The IRS also provided a transition rule for arrangements that do not comply with the release timing rules but are corrected before December 31, 2012. If payments under these arrangements could be paid during a period that begins in 2012 and ends in 2013, the payments must be provided in 2013 and the arrangements must be amended no later than December 31, 2012, to be compliant with the Section 409A release timing rules described above. Tax and monetary penalties generally should not apply in these cases.

Section 409A Tax Penalties

The penalties for violating Section 409A largely fall on employees and include immediate income tax inclusion, an additional 20 percent federal penalty tax, and interest charges (and in California, an additional 20 percent state penalty tax). In most cases, amending an arrangement by December 31, 2012, to comply with the release timing rules should not result in any tax or monetary penalties.

Action Items

Employers should review compensation arrangements that condition severance and other compensation on the signing of a release of claims in order to identify and correct any noncompliant provisions in advance of the December 31, 2012, deadline for amendment.