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Severance Payments Must Comply with IRS Section 409A Before December 31, 2012

                Employers should immediately look at their severance and other post termination payment plans (“Severance Agreements”) to verify that these agreements comply with Section 409A of the Income Tax Regulations. Failure to correct any such deficiencies will subject employees to a penalty of a 20% additional tax and underpayment interest penalties on compensation not properly included in income.   December 31, 2012, is the last day to revise certain nonqualified deferred compensation plans which do not comply with Section 409A of the Income Tax Regulations without having to pay the penalties.           

                Section 409A regulates the timing of compensation payable on a deferred basis and states that all amounts deferred under a nonqualified deferred compensation plan must be included in income in the year that the compensation is paid, or the year that it is not subject to a substantial risk of forfeiture, whichever occurs first.  The former scenario, the year during which it is paid, is easy to determine.  It is under the latter scenario (that compensation must be included in income in the year it is no longer subject to a substantial risk of forfeiture) that taxpayers get into trouble. Compensation is subject to a “substantial risk of forfeiture” if entitlement to the payment is conditioned on the performance of future services by any person, or the occurrence of a future condition.  There are many forms of compensation that an employee may receive which are considered deferred compensation and which may be improperly reported by an employer.  The failure to accurately report deferred compensation will subject the taxpayer to substantial additional taxes and interest penalties.   

                Many Severance Agreements will be exempt from the provisions of Section 409A.  The most common type of Severance Agreements which are not considered deferred compensation are those that apply when there is an involuntary separation of employment, and the severance payments are no greater than two times: i) the employee’s annual taxable compensation in the year prior to the termination year; or ii) the limits on compensation set forth in Section 401(a)(17) of the Income Tax Regulations.   These payments must also be complete no later than December 31st of the second calendar year following termination of employment.

                If Severance Agreement payments do not meet the above criteria, they may fall within the nonqualified deferred compensation category and are then governed by Section 409A of the Income Tax Regulations.  The IRS has extended the time to revise Severance Agreements that do not comply with Section 409A due to the inclusion of the standard language related to a review and revocation period after an employee executes the agreement.  If an employee is terminated at the end of the year, is provided with a separation agreement or release, and has a period of time to review and revoke the Severance Agreement, the employee has the discretion to decide in what tax year the compensation will be paid.  This clearly violates Section 409A.   Another example of a provision in a Severance Agreement which would violate Section 409A, would be a provision in an employment agreement which states the employee will be paid a severance payment within sixty (60) days of termination.  If the employee is terminated at the end of a year the payment could be made within two separate calendar years.  This would violate Section 409A.

                Severance Agreements may be amended to state that the severance payments will be made on a specified date after termination so long as the employee has executed and not revoked the required documents.  The date of payment must be set within ninety (90) days of termination.   Employers can also amend Severance Agreements to state that payments will be made within a specified period of time (i.e., within ninety (90) days after separation of employment), so long as there is language indicating that if that period of time ends in the following year, payment will be made in the following year. These provisions allow the employer, not the taxpayer, to determine in what year the compensation will be paid.

                Employers should also verify that definitions set forth in Severance Agreements and other employment documents are clear and unambiguous.  The term “termination of employment” has been determined to be ambiguous enough to violate Section 409A in certain situations.   There have been disputes over whether termination occurs when an employee changes his or her relationship to the company from that of an employee to that of an independent contractor, or when an employee moves from an affiliate company to the parent company.  Clauses that appear to be self-explanatory may quickly become ambiguous. Adding a provision to any Severance Agreement documents which state the “agreement must be interpreted to comply with the requirements of Section 409A of the Income Tax Regulations” will provide some extra protection in the case of any ambiguous terms.

                Although the safe harbor from penalties is no longer available as of December 31, 2012, Employers should still immediately amend Severance Agreements, which may include employment agreements, termination and release agreements, and change in control agreements, to fully comply in the future; otherwise taxpayers may face substantial penalties.

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