IRS Penalty Relief for Severance Pay Expires on December 31

The IRS has given employers until December 31, 2012 to correct a problem frequently found in severance agreements and other similar arrangements. If not corrected by that date, it could be much more expensive to correct the problem. In this article, we discuss the problem and how to fix it.

Employers often pay severance to terminating employees in exchange for a non-compete agreement, a non-solicitation agreement, or to settle potential claims. Sometimes the severance is a lump sum amount paid shortly after the employee’s departure. Sometimes severance is paid in installments over several months, perhaps to encourage continuing good behavior. Most employers are not willing to pay severance unless they have some protection from litigation. So, employers typically ask terminating employees to release all claims that they may have against the employer in exchange for the severance.

Problem

Anytime a payment of deferred compensation is contingent upon the employee signing a release, or some other agreement such as a noncompete, the employee has some ability to manipulate the timing of the payment, and perhaps even the year in which the payment will be made. The IRS says that this ability to manipulate the payment timing violates Code Section 409A, and could cause the employee to owe substantial penalty taxes. 
   
Example

If an agreement provides that an employee terminated without cause will receive 12 months of continuation pay if the employee signs a release of claims, the employee can manipulate the timing of the payments if the employee is terminated late in the year. By signing the release quickly or slowly, the employee can start the payments in the year of termination or the next year. This very common contract provision violates Section 409A.

IRS Relief Available
   
Because the Section 409A regulations do not clearly address the issue, this release provision is very common, and many existing agreements require correction, including agreements that were amended in 2008 to comply with Section 409A. 

The IRS is, therefore, giving employers until the end of 2012 to fix the offending language, in many cases without penalty. Before the end of the year employers must revise all existing agreements to adopt permissible release language, such as by requiring payment on a specific day, such as the 60th or 90th day following termination of employment, or during a specified period of 90 days or less, provided that if that 90-day period spans two years, payment will always occur in the later year regardless when the release is signed.

This problem and the IRS relief applies not just to employment and separation agreements, but also to any arrangement with a severance feature, including nonqualified retirement plans, equity awards, and change in control agreements. 

No correction is necessary for agreements or arrangements that were fully paid out prior to March 31, 2011. Special rules apply to arrangements that provide for payments between March 31, 2011 and December 31, 2012. Any arrangement that provides for payments after December 31, 2012, should be corrected by that date under the IRS relief.

No Relief Available
   
Agreements or arrangements prepared after December 31, 2010 are not eligible for this relief. However, agreements or arrangements prepared after December 31, 2010 that do not comply with the release timing rules may be corrected in accordance with the IRS general 409A document correction program, which provides relief from the Section 409A penalty taxes for documents that are corrected before the affected employee is terminated. 

Action Required
   
Before the end of 2012, employers should review and, if necessary, correct all separation pay agreements, employment agreements, change in control agreements, and nonqualified plans that provide for payments contingent upon the employee executing a release of claims or some other agreement such as a non-compete. That review should include agreements and plans that provide for payments to be made anytime after March 31, 2011, even if those payments have begun or have been completed.