Publications: Deferred compensation payments

If you don't spend your practice buried in the Internal Revenue Code, you may be inclined to skip this article.

Before you decide that Section 409A does not apply to your practice, ask yourself whether you typically draft employment or severance agreements that pay a deferral of compensation (e.g., certain severance payments) (1) later than 90 days after the employee's separation from service, or (2) contingent upon an employment-related action (e.g., the execution and submission of a noncompete, nonsolicitation or general release). If you answered yes, you may be interested in knowing what the IRS considers a "document failure" under Section 409A. By doing so, your client may avoid adverse tax consequences.

Last year, the IRS issued two key pieces of guidance that interpret Section 409A. Before we examine the guidance and whether such guidance may affect how you draft employment or severance agreements, we must first generally discuss Section 409A.

Please note, Section 409A and the underlying Treasury regulations are complex. You should conduct a careful analysis, based on your own facts and circumstances, to determine whether compensatory payments owed under an agreement comply with (or satisfy an exception from) Section 409A.

Section 409A
As part of the American Jobs Creation Act of 2004, Congress added Section 409A to the revenue code to curtail perceived abuses in executive compensation practices. Section 409A dramatically increased the federal regulation of deferred compensation. Generally, it imposes numerous requirements regarding deferral elections, permissible payment events, prohibition on the acceleration of payment and restrictions on funding.

Section 409A covers "any plan that provides for the deferral of compensation" including, but not limited to employment, severance and bonus arrangements as well as traditional nonqualified plans.

A plan that provides for a "deferral of compensation" must comply with Section 409A in form and operation. Many terms used in Section 409A are specifically defined by the Treasury regulations; the IRS has evidenced a strict interpretation of the statute.

Tax consequences for noncompliance
Noncompliance with Section 409A can be very costly. Generally, all employees covered by a plan or agreement, in the case of a document failure, must take all deferred compensation (current and all prior tax years) into current gross income, to the extent vested.

Employees are also subject to an additional tax equal to 20 percent of the compensation required to be included in gross income. Further, the tax due is increased by interest at the underpayment rate plus 1 percent from the year in which the amount was first deferred or was no longer subject to a substantial risk of forfeiture, if later.

2010 IRS guidance
IRS Notice 2010-6 created a document correction program that permits eligible taxpayers to voluntarily correct certain Section 409A "document failures."

Generally, Sections V through XI of the IRS notice describe the document failures that are eligible for correction, the correction method required by the IRS for each document failure and the applicable relief.

Document failures eligible for correction include (1) impermissible definitions of "separation from service," "change in control" and "disability," (2) impermissible payment periods following permissible payment events (discussed herein), (3) impermissible payment events and schedules, (4) failure to include a six-month delay for payments to specified employees and (5) impermissible deferral elections.

Last November, the IRS released Notice 2010-80, which partially amended Notice 2010-6. If an agreement is corrected in a manner consistent with Notice 2010-6, as amended, the employee will not be required to include all or a portion of the deferred compensation in income. In some cases, the taxpayer can also receive relief from the 20 percent additional tax and/or the interest described above.

The purpose of this article is neither to examine the procedures of the document correction program nor to provide instruction on how to correct document failures (under executed agreements), whether inside or outside the program. Rather, the purpose is to examine two common document failures and their correction methods to gain a better understanding of how future employment or severance agreements should be drafted.

Payment periods exceeding 90 days
Section VI.A.1 of Notice 2010-6 provides that a payment period (during which payment of deferred compensation may be made or commenced) that exceeds 90 days following a permissible payment event (e.g., "separation from service" as defined by Section 409A) is a document failure eligible for correction.

As evidenced by the required correction method in Section VI.A.2 of Notice 2010-6, an agreement governed by Section 409A must require payment during a period that does not exceed 90 days following the permissible payment event and the employee must not have a right to designate the taxable year of payment.

If your agreement contains a "deferral of compensation" and does not satisfy an applicable exception to Section 409A, the agreement should be drafted to satisfy the standard of the correction method described above.

Payment conditioned on employment-related actions
Section VI.B.1 of IRS Notice 2010-6 provides that a payment upon a permissible payment event (e.g., "separation from service") that is conditioned on an employment-related action of the employee (e.g., the execution of a release of claims) is a document failure eligible for correction.

As evidenced by the required correction method in Section VI.B.2 of Notice 2010-6, an agreement governed by Section 409A must not permit an employee to delay or accelerate the timing of his deferred compensation payment due to his employment-related actions.

Apparently, the IRS was concerned that late-year terminees could accelerate or delay payment by quickly taking (or not taking) action and, thus, could select the taxable year in which deferred compensation was recognized.

As amended by Notice 2010-80, Section VI.B.2 of the Notice 2010-6 now requires that payment subject to an employment-related action be made either (1) upon a fixed date that is either 60 or 90 days following the occurrence of the permissible payment event, or (2) during a specified period no longer than 90 days following the occurrence of the permissible payment event, with the condition that if the specified period begins in one taxable year and ends in a second taxable year, the payment will be made in the second year.

Example 5 of Section VI.B.2 of Notice 2010-6 (as added by Notice 2010-80) provides a good illustration of these concepts.

Employer and Employee N amend an employment agreement to provide Employee N $100,000 within 90 days following Employee N's separation from service, as long as Employee N signs a noncompete agreement within the 90-day time period. The agreement also provides that if the 90-day period starts in one taxable year and ends in a second taxable year, the payment will be made in the second taxable year regardless of when N signs the noncompete agreement. Employee N separates from service on Dec. 1 of this year and signs his noncompete agreement on Dec 15 also of this year. Employer pays $100,000 to N on Jan. 1, 2012.

Practitioners should review the correction methods contained in Notice 2010-6, as amended, to gain a better understanding of how employment and severance agreements should be drafted when deferrals of compensation (e.g., certain severance payments) are conditioned on employment-related actions.

Reprinted with permission from Law Bulletin Publishing Company.