IRS Extends Deadline to Amend Employment Agreement Release and Contingent Payment Provisions to Comply with 409A
On November 30, 2010, the Internal Revenue Service (IRS) released Notice 2010-80 (the New Notice), which modified guidance the IRS had previously issued earlier this year in Notice 2010-6 (the Original Notice) regarding correction methods available to employers for failures to comply with Section 409A of the Internal Revenue Code of 1986, as amended (the Code).
In the Original Notice, the IRS disclosed a new rule that if a payment is contingent upon a service provider’s execution of a document, such as a release of claims, non-competition agreement or non-solicitation agreement, the payment would not be compliant with Section 409A unless certain requirements were met. The Original Notice permitted amendments to non-compliant documents so long as they were made on or prior to December 31, 2010.
The New Notice provides additional guidance on methods to correct non-compliance in such situations and extends the deadline for documentary compliance through December 31, 2012.
In the Original Notice, the IRS described various correction methods for failures under Section 409A. Section 409A governs all deferred compensation (which is defined extremely broadly). To the extent a deferred compensation arrangement does not comply with the provisions of Section 409A, a 20 percent penalty tax is imposed on the recipient of payments made under such arrangement (in addition to applicable federal, state and local income taxes).
As described in our December 1, 2010, Alert regarding Notice 2010-6, in Section VI(B) of the Original Notice, the IRS announced a new position regarding deferred compensation that becomes payable only once the service provider executes a document, such as a release of claims, a non-competition or non-solicitation agreement or a similar document. As a result of the IRS’s concern that service providers could control the tax year in which the compensation would become payable by choosing to sign the document in the current tax year or waiting until the next tax year to sign the document, the IRS required that such arrangements provide for a fixed date on which the service provider must receive payment or forfeit the compensation. In the Original Notice, the IRS permitted service recipients to amend their deferred compensation arrangements which were contingent upon the service provider’s execution of a document on a one time basis to comply with Section 409A, so long as: (1) such amendment was executed prior to December 31, 2010 (and prior to the event that triggered the payment); (2) neither the service provider nor the service recipient were under audit when the amendment was made; (3) the service provider and the service recipient each attached statements to their tax returns for 2010 disclosing the amendment and the correction; and (4) the service recipient and its affiliates took reasonable steps to correct similar provisions in its other deferred compensation arrangements.
The New Notice provides: (1) additional methods of correcting non-compliance in situations where deferred compensation is contingent upon the execution of a release or similar agreement; (2) additional transitional relief in correcting such failures that were in effect on or prior to December 31, 2010; and (3) relief from the service provider information reporting requirements.
Additional Methods of Correction
Under the New Notice, when a non-compliant arrangement provides for a period of time in which a document may be executed, the arrangement may be amended to comply with Section 409A by providing that either: (1) regardless of the date of execution, the payment will be made on the last day of the time period; or (2) to the extent the period of time for execution spans two taxable years, the payment will be made only in the second taxable year. Additionally, under the New Notice, when an arrangement does not provide for a period of time in which the document may be executed, the arrangement may be amended to comply with Section 409A by providing that either: (1) the payment will be made on the 60th or 90th day following the event that triggers the payment if the document has been executed prior to such date; or (2) the payment will be made during a specified period (not longer than 90 days) following the event that triggers the payment, on the condition that if the period of time spans two taxable years, the payment will only be made in the second taxable year.
Under the New Notice, the amendment must still be made prior to the occurrence of the event that triggers the payment.
Additional Transitional Relief
If an arrangement was non-compliant with respect to this type of situation on or prior to December 31, 2010, the arrangement will not be treated as non-compliant if the payment occurs prior to March 31, 2011. With respect to non-compliant arrangements with payments occurring after March 31, 2011, the arrangement will not be treated as non-compliant: (1) if the arrangement has a period of time where the service provider can receive the payment spans two taxable years, the payment is made only in the second taxable year; and (2) with respect to arrangements with amounts paid or payable after December 31, 2012, the arrangement has been corrected by such date.
Relief from Information Reporting Requirements
Under the New Notice, if the non-compliant arrangement is amended prior to December 31, 2012, the service provider will not have to attach a statement to their tax return disclosing the amendment and the correction. The requirement under the Original Notice that service recipients attach statements to their tax returns disclosing the amendment and correction remains unchanged.
Exceptions to 409A
There are various exceptions to Section 409A. Qualified plans, such as pension and 401(k) plans are excluded from Section 409A, as are welfare benefits, disability pay, death benefits, separation pay plans and collectively bargained severance arrangements. Additionally, payments made within the “short-term deferral period” (two and a half months within the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture) are excluded from Section 409A. Finally, certain equity compensation, including non-discounted stock options, restricted stock and stock appreciation rights are excluded from Section 409A. These exceptions are important to consider when determining whether a deferred compensation arrangement will need to be amended pursuant to the new IRS position announced in the Notice.