IRS Provides Guidance for Correcting Documentary Errors Under Section 409A; Takes a Hard Line on Releases and Severance Benefits
Corporate & Finance and Employment Alerts
March 3, 2010
The IRS recently issued Notice 2010-6, its correction program for nonqualified deferred compensation arrangements that do not satisfy the documentary requirements of Section 409A of the Internal Revenue Code. This Alert focuses on the transition relief for correction of documentary errors by December 31, 2010, and the IRS position on releases and severance benefits.
Section 409A establishes complex rules regarding the timing of initial deferral elections, the timing and form of payments of deferred compensation, and a prohibition on acceleration of payments of deferred compensation. Since Section 409A broadly defines a nonqualified deferred compensation arrangement, Section 409A can apply to employment agreements and change-in-control agreements that provide for severance benefits on an employee’s separation from service.
Thus, Section 409A applies to traditional nonqualified deferred compensation arrangements, such as bonus deferral plans and supplemental executive retirement plans, and can also apply to any arrangement in which an employer pays an employee compensation after March 15 following the taxable year in which the employee earns and vests in the compensation.
As a result of Section 409A’s broad applicability, a broad range of deferred compensation arrangements is subject to the risk of having documentary error. An arrangement has a documentary error when it contains a provision that violates Section 409A, or does not contain a provision required by Section 409A. An arrangement can also have an operational failure, which occurs when the arrangement is not administered in accordance with its terms. The IRS previously issued its correction program for operational failures in Notice 2008-113.
One of the key components of Notice 2010-6 that it grants employers and employees transition relief until December 31, 2010 to correct documentary errors. In the absence of an operational failure, the parties can correct documentary errors without the employee recognizing income, and without the employee’s payment of an additional 20% tax on this income.
For example, a bonus deferral plan provides for payment of a $100 bonus on July 1 of the fifth year after the year in which the employee earns and vests in the bonus. The plan provides for payment in three annual installments unless the employer determines in its exclusive discretion to pay the bonus in a single lump sum. The grant of discretion to the employer violates Section 409A. As a result, for the year in which the employee earns and vests in the bonus, the employee recognizes $100 in income, and must pay regular income tax and an additional 20% tax on this income. Under Notice 2010-6, the parties can amend the plan by December 31, 2010 to eliminate the employer’s discretion, and provide solely for the three annual installment payments without any tax consequence to the employee.
The most important requirements to qualify for the transition relief are as follows. Any payment made before December 31, 2010 that would not have been made under the corrected provision, or any payment not made before December 31, 2010 that would have been made under the corrected provision, is treated as an operational failure. Operational failures must be corrected under Notice 2008-113.
Second, the employer must take commercially reasonable steps to identify and correct all other arrangements with the same or substantially similar errors.
Third, neither the employer’s nor the affected employee’s federal income tax return must be under examination with respect to nonqualified deferred compensation for any taxable year in which the documentary error existed.
Most importantly, an employer must attach to its federal income tax return for the taxable year in which it corrects the error a statement regarding the correction. The employer must also provide the employee with a similar statement, and the employee must attach this statement to the employee’s federal income tax return for the taxable year in which the error was corrected.
Since the final Section 409A regulations became effective on January 1, 2009, there has been significant controversy regarding the timing of an employee’s execution of release, and the employer’s payment of severance benefits to the employee. In Notice 2010-6, the IRS takes a hard line on this issue. The Notice provides the following guidance when an arrangement conditions payment on an employee’s execution of a noncompetition agreement, a nonsolicitation agreement, or a release of claims. The concern of the IRS is that the employee, by determining when to execute an agreement, can select the taxable year in which the employee receives payments. The ability to select the taxable year for receipt of payments is prohibited by the Section 409A regulations.
Notice 2010-6 provides that the parties can correct the documentary error before the date an event occurs that would be a permissible payment event, such as the employee’s separation from service. The parties can amend the document to remove the employee’s ability to delay or accelerate the timing of the payment. If the document provides for payment, subject to the employee’s executing a separate agreement, within a designated period after the payment event, the amendment must provide for payment only on the last day of that designated period. If the document does not provide for payment, subject to the employee’s executing a separate agreement, within a designated period after the payment event, the amendment must provide for payment only upon a fixed day either 60 or 90 days after the payment event. The amendment cannot otherwise change the time or form of payment.
Notice 2010-6 provides the following two examples. In the first example, Employee M is an employee of Employer whose employment agreement entitles Employee M to $100 on separation from service. The employment agreement provides that the amount is payable within 90 days after the date of Employee M’s separation from service, but not until Employee M executes and submits a release of claims, and any period during which Employee M may revoke the release pursuant to applicable law has expired before the end of the 90 day period. If Employee M fails to execute the release, the amount is forfeited.
On April 1, 2011, Employer and Employee M amend Employee M’s employment agreement to provide for payment on the 90th day after Employee M’s separation from service as long as Employee M has executed and submitted a release, and the statutory period during which Employee M may revoke the release has expired on or before that 90th day. Employee M has separation from service on June 1, 2011, and Employee M executes and submits a release on June 30, 2011. Employer pays Employee M $100 on August 30, 2011.
Since the Employer and Employee M corrected and amended the employment agreement before Employee M’s separation from service, and because the Employer paid the amount in compliance with the amended provision, Employee M is not required to include any amount in income solely due to the precorrection provision.
In the second example, Employee N is an employee of Employer whose employment agreement entitles Employee N to $100 on separation from service. The employment agreement provides that the amount is payable upon Employee N executing and submitting a release of claims, and after any period during which Employee N may revoke the release pursuant to applicable law has expired. The agreement does not contain any time limit for payment.
On April 1, 2011, Employer and Employee N amend Employee N’s employment agreement to provide for payment of $100 on the 60th day after Employee N’s separation from service as long as Employee N has executed and submitted a release, and the statutory period during which Employee N is entitled to revoke the release has expired on or before that 60th day. Employee N has a separation from service with Employer on June 16, 2011. Employee N executes and submits a release on July 1, 2011. Employer pays Employee N $100 on August 15, 2011.
Since Employer and Employee N corrected the provision before Employee N’s separation from service, Employee N is not required to include any amount in income solely due to the precorrection provision.
Many employment agreements, change-in-control agreements, and severance agreements that condition payment of severance benefits on execution of a release do not satisfy the position taken by the IRS regarding the timing of an employee’s execution of a release and the employer’s payment of benefits. Accordingly, employers should carefully review their agreements to see whether they satisfy the IRS position, and if they do not, employers should consider whether correction under Notice 2010-6 is appropriate.