By Timothy A. Daum, CEP, CPC, CEBS, EA
The deadline for employers that need to correct any violations of Internal Revenue Code (IRC) Section 409A that result from deferred compensation payments being contingent upon an employee’s completion of certain employment-related actions (for example, the execution and submission of a release of claims, a noncompetition agreement, or a nonsolicitation agreement) is Dec. 31, 2012. Types of arrangements that often include such provisions include deferred compensation plans, employment agreements, severance plans, and change-of-control agreements.
How to Comply
A properly drafted arrangement can include such a provision and still comply with 409A, but an improperly drafted arrangement will result in a 409A violation. In order to avoid a 409A violation, an arrangement cannot make it possible for an employee to manipulate the timing of income inclusion based on when he or she completes an employment-related action.
For example, if an employee is terminated on Dec. 1, 2012, and is entitled to deferred compensation payments that will commence as soon as possible following the employee’s execution of a release of claims (and the expiration of the waiver period relating to such release), then the employee controls whether payments will commence in 2012 or 2013. If the employee prefers to include the initial payment in his or her 2012 taxable income, then he or she can execute and submit the release of claims immediately. On the other hand, if the employee prefers to defer receipt of the initial payment until 2013, he or she can wait until late December or early January to execute and submit the release of claims. This type of employee control over the timing of deferred compensation payments is prohibited by 409A.
Internal Revenue Service Notice 2010-80 allows an existing arrangement that contained the prohibited provision as of Dec. 31, 2010, to be corrected no later than the earlier of Dec. 31, 2012, or the occurrence of a payment-triggering event to which the prohibited provision applies. Following are the permissible methods of correction under Notice 2010-80:
- If the arrangement currently provides for payment to be made or to commence within a specified period of time following the payment-triggering event, and such time period complies with 409A except for the prohibited language regarding the required employment-related action, then the arrangement can be amended to require either of the following:
- Payment will be made or will commence on the last day of the specified period.
- Payment will be made or will commence in the second calendar year if in any event the designated period begins in one calendar year and ends in another calendar year.
- If the arrangement does not currently provide for payment to be made or to commence within a permissible specified period of time following the payment-triggering event, then the arrangement can be amended to require any of the following:
- Payment will be made or will commence on the 60th day following the payment-triggering event.
- Payment will be made or will commence on the 90th day following the payment-triggering event.
- Payment will be made or will commence within a specified period of time beginning with the date of the payment-triggering event and ending no later than 90 days following the payment-triggering event, with the condition that if the specified period begins in one calendar year and ends in another calendar year, then payment will be made or will commence in the second calendar year.
About Section 409A
IRC Section 409A was effective Jan. 1, 2005. Any compensation that is deferred or that becomes vested after Dec. 31, 2004, potentially is subject to 409A. In addition, pre-2005 deferrals can be subject to 409A if the arrangement is materially modified after Oct. 3, 2004. Deferred compensation arrangements (defined very broadly in the regulations) must be structured to either comply with or be exempt from 409A.
Failing to comply with 409A (either a plan document failure or an operational failure) generally results in the following adverse tax consequences for affected individuals:
- All compensation deferred under the arrangement and all other arrangements of the same type is includable in income for the year of the failure to the extent such compensation is vested and has not been previously included in income.
- An additional 20 percent tax is assessed on such compensation.
- A third tax is assessed on such compensation to the extent the compensation vested in a previous year. The tax assessed is based on the interest that would have accrued on unpaid income taxes had the deferred compensation been includable in income for the year in which it first became vested. This third tax is referred to as the “premium interest tax” since it is based on the underpayment rate plus 1 percent.
Employers should determine whether they have any arrangements that need to be amended. Those that fail to correct violations by the Dec. 31 deadline could be subjecting key employees to hefty penalties.
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