Jones & Keller Tax Alert: §409A Transition Relief Deadline
Tax Alert: §409A Transition Relief Correction Deadline for Release Timing Errors is December 31, 2012
Employers have until December 31, 2012 to correct “Release Timing Errors” in any deferred compensation plan or arrangement subject to §409A. A Release Timing Error is a provision in a deferred compensation arrangement subject to §409A which requires the employee to take certain employment-related actions (e.g. executing a waiver and release of claims agreement or a non-competition or non-solicitation agreement or returning company property) before the compensation will be paid and such provision does not comply with Section 409A of the Internal Revenue Code of 1986, as amended (“§409A”).
Any deferred compensation arrangement subject to §409A which requires employment-related action by the employee before payment is made to the employee should be reviewed and, if necessary, be amended to bring such arrangement into compliance with §409A. Failure to amend such arrangement to correct a Release Timing Error could cause the employee to be subject to significant penalties under §409A, including the inclusion of the deferred compensation into income for federal income tax purposes prior to the payment being made, the imposition of a 20 % federal excise tax and a higher rate of interest on any late payments as a result of the §409A violation.
What is a Deferred Compensation Plan for §409A Purposes?: §409A regulates deferred compensation plans. A deferred compensation plan, for §409A purposes, is any arrangement, plan or individual agreement which provides for the deferral of compensation. The following arrangements may have features that will cause them to be treated as nonqualified deferred compensation plans under 409A (this is not an exhaustive list, but merely a list of the most common arrangements):
- Employment and consulting agreements;
- Equity compensation plans providing for the grant of stock options, stock appreciation rights, phantom stock units, restricted stock, performance units, restricted stock units and/or deferred shares, and all related amendments and award agreements;
- Voluntary and mandatory deferred compensation plans and arrangements;
- Severance plans, change-in-control plans and separation agreements;
- Long-and short-term incentive plans; and
- Supplemental executive retirement plans and agreements.
The Issue: The linking of the timing of the payment of deferred compensation with the timing of an employee’s action (i.e. the signing of an agreement) violates §409A if it is possible for the employee to delay or accelerate the timing of the payment as a result of the employee’s actions. This problem can arise, where there is required employment-related action and where (a) the payment is to be made within a certain time period (a “Payment Period”) and not on a date certain, (b) there is no set Payment Period or date certain when the payment is to be made, (c) there is no Payment Period or date certain when the employment-related action must be completed, (d) the timing of the payment is dependent upon the employment-related action, or (e) a combination or one or more of the above.
In each of the above scenarios, if the event triggering the payment is close to the end of the year, the employee can manipulate in which year the payment is to be made by timing of the completion of the employment-related action. For example, if the employee wants the payment to be made in the following year, the employee does not complete the employment-related action until the following year.
The Correction: An arrangement eligible for correction must be corrected before the date the event occurs that would trigger the payment under the arrangement. Depending upon language of the arrangement, the arrangement must be amended to provide that payment will be made on a fixed date (e.g. the last day of the Payment Period, or if none, 60 or 90 days after the triggering event). In the alternative, the amendment can provide that if the Payment Period covers two tax periods that the payment will be made in the second tax period regardless of when the employer-related action is completed.
In addition, we recommend that any arrangement requiring employment-related action provide that such action must be completed by a date certain and if such employment-related action is not completed by such date that that the employee forfeits the deferred compensation. Note that the time period by which the employment-related action must be completed must be long enough to meet any federal and state required time periods for waiver of claims, etc., but short enough that when any mandatory rescission period is included that the two are not longer than the end of the Payment Period.
Examples: The following are examples of arrangements which are not exempt from §409A:
Example A: An employment agreement provides for a lump sum payment upon the termination of employment and that (1) the payment will not be paid until the employee executes and delivers a release and waiver of claims agreement and (2) that the payment will be made on the first Friday following the delivery of the executed release and waiver of claims agreement. The employment agreement does not provide a date certain by when the employee must return the fully executed release and waiver of claims agreement. The employee is terminated on December 1, 2011. The employment agreement does not comply with the §409A release timing rules because the employee could manipulate the timing of the payment between tax years. The employee could wait to sign the release and waiver of claims agreement until after December 31, 2011, thus ensuring the payment is paid in the later year. The employment agreement should be amended in accordance with §409A.
Example B: Same facts as Example A, except that the employment agreement provides that the fully executed release and waiver of claims agreement must be returned to the employer within 50 days following the date of termination or else the employee forfeits the payments. The employment agreement does not comply with the §409A release timing rules because the employee could possibly manipulate the timing of the payment between tax years. The employment agreement should be amended in accordance with §409A.
Example C: Same facts as Example A, except (1) that the employment agreement provides that the fully executed release and waiver of claims agreement must be returned to the employer within 60 days following the date of termination or else the employee forfeits the payments, and (2) regardless of when the fully executed release and waiver of claims agreement is provided, the payment will be paid on the 60th day following termination. The employment agreement complies with the §409A release timing rules and does not need to be amended.
Transition Relief Deadline: The IRS published special transition relief for deferred compensation arrangements in existence prior to December 31, 2010, which do not comply with §409A due to Release Timing Errors. If these arrangements are revised no later than December 31, 2012 with respect to payments payable after December 31, 2012 no §409A taxes/penalties will be due and owing on the amounts payable pursuant to such plans. That being said, the employer is required to file a statement with its corporate tax return identifying such correction.
For deferred compensation arrangements which were not in place on December 31, 2010 or which were in place on December 31, 2010 but are not amended prior to December 31, 2012, these should still be reviewed and corrected, but they will not be eligible for the relief above. In these situations (a) such amendment must be completed prior to the occurrence of the triggering event, (b) both the employer and the employee must file a statement with their tax return, and (c) all arrangements between the company and any other employees which have the same or similar release timing errors must be corrected at the same time.
Recommended Client Action:
Review all plans, agreements and arrangements to which §409A might apply to determine if there is a §409A Release Timing Error issue. The Release Timing Error issue may affect arrangements which were previously reviewed and corrected for §409A compliance in previous years.
THIS TAX ALERT MAY CONTAIN INFORMATION CONCERNING A FEDERAL TAX ISSUE OR ISSUES AND IS NOT INTENDED TO BE USED, AND MAY NOT BE USED, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER BY THE INTERNAL REVENUE SERVICE.