IRS Section 409A Relief Expires at Year End; Act Now to Avoid Penalties

Employers, take note: tax relief for nonqualified deferred compensation plans – agreements to provide payment for services in exchange for a signed release – is due to expire at the end of the year.

That means that employers and employees will need to review any such arrangements, which could include equity, nonqualified retirement, and severance or other employment agreements, to ensure compliance with the latest 409A guidance or face harsh penalties.

Here’s how:

1. What agreements to review?

“Any arrangement providing payments that are conditioned upon an employment-related action of the employee (such as the execution of a release or restrictive covenants) must be revised to remove the ability of the employee to delay or accelerate the timing of the payment. Severance payments typically require an employee to sign a release of all claims against the employer, and no payments are made until the employer receives an executed release. Some employers require an executed release before an employee can receive long-term incentive or other payments.” (McDermott Will & Emery)

2. What to change?

“IRS Notices 2010-6 and 2010-80 offer corrective relief by providing that … documentary failures can be corrected by either of the following methods:

  • Providing for payment on a fixed date (such as on the 60th day following separation) so that delivery of the release does not affect payment timing.
  • Providing that any payment that could be paid over a release consideration and revocation period beginning in one taxable year and ending in the subsequent taxable year will be paid in the subsequent taxable year (again, so that release delivery does not affect payment timing).

Applicable transition relief under IRS Notice 2010-80 requires that payments under an arrangement with a nonconforming release provision triggered between March 31, 2011, and December 31, 2012, must be administered by paying in the later taxable year where an applicable release period spans two taxable years.” (Morgan Lewis)

3. What happens if the deadline is missed?

“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.” (Wilson Sonsini)

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