December 31 Deadline For Correcting Release Of Claims Provisions That Fail To Comply With Section 409A

Employers preparing for year-end compliance efforts should be aware of a December 31, 2012 deadline for correcting a common problem in compensation arrangements subject to Section 409A of the Internal Revenue Code.

The problem relates to plans and agreements that condition payment on an employee-related action such as the giving of a release of claims.1 Where an employee's ability to time a release may affect the timing of payments, the employee's discretion to affect payment timing may result in a violation of 409A. A violation of 409A in turn may result in early income inclusion, a 20% additional federal income tax, and other taxes and tax-related penalties.

Relief for problems arising out of this common fact pattern is available under the IRS's 409A documentary corrections program, originally published in Notice 2010-6 and subsequently amended by Notice 2010-80 (together, the "Notice"). In some cases, however, relief from employee notice requirements is available only if action is taken by December 31, 2012.

Problematic Payment Arrangements

The potential issue and the relief available under the Notice arise only with respect to payment arrangements subject to 409A. Fortunately, many arrangements that provide for payment after a release are exempt from 409A (e.g., short-term deferrals and certain severance obligations). Employers with agreements or plans of this type should first determine whether payments under the arrangement are subject to 409A.

Relief Available Generally

Under the Notice, corrective amendments can generally be made without adverse 409A consequences at any time before the payment-triggering event (e.g., termination of employment). Where the non-compliant arrangement specifies a designated period of not more than 90 days during which a release must be executed or become effective, the arrangement can be amended to require that payment be made either (i) on the last day of the designated period following the occurrence of the triggering event or (ii) at any time during the designated period, except that if the designated period straddles two taxable years, in the later taxable year. Similar corrections are available if no period for signing the release is designated.

This general correction method requires the employer to attach a statement regarding the correction to its tax return for the year in which the correction is made and to provide the affected employee with a statement that the employer has taken the...