Year-End Deadline to Correct Section 409A Violations Relating to Payments Conditioned Upon a Release of Claims
Taxpayers have one last chance to correct eligible covered arrangements (those in effect on or before December 31, 2010) that violate Section 409A of the Internal Revenue Code because the time of payment of the underlying compensation is based upon certain action(s) by the service provider. The deadline is December 31, 2012.
What is the problem?
Compensation subject to Section 409A can only be paid upon one or more Section 409A trigger events – namely, a set date or schedule, disability, a separation from service, an unforeseeable emergency or a change in control (as defined in each case under Section 409A) or death. Where the applicable compensation is contingent upon action by the employee, consultant, contractor or other service provider (referred to generally as a “service provider”) – such as the execution of a release of claims, non-compete or similar agreement – there is a violation of Section 409A if the service provider can manipulate the timing of the payment by when he or she takes the required action. For example, if a severance payment is to be paid as soon as administratively practicable after termination of employment but is contingent upon the execution of a release, an employee who terminates employment late in the calendar year could defer payment into the next calendar year by simply waiting to sign the release.
What happens if the problem is not fixed?
Section 409A imposes a 20% tax (in addition to normal income taxes) upon covered compensation that violates Section 409A. Additionally, the service provider will have to recognize the compensation as taxable income when it becomes vested (as opposed to when it is paid), and the service provider will owe penalty interest (at the underpayment rate plus 1%) from the date the compensation should have been included in taxable income until the date the taxes are paid. The employer will be required to (i) report the compensation as taxable income in the year it becomes vested and (ii) code the reported compensation in a way that will disclose that the compensation is subject to the additional 20% tax.
How can the problem be fixed?
Eligible covered arrangements must be amended by December 31, 2012 (and prior to the occurrence of the event triggering payment of the compensation) to correct the problem. The arrangement must be corrected to remove the ability of the service provider to manipulate the timing of the payment as a result of the service provider’s action or inaction. The IRS has provided examples of ways to fix the problem:
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Arrangements that provide for payments to be made in a specified period following termination of employment (e.g., 60 days after termination of employment) can be amended to specify either (a) that the payment will be paid on the last day of the specified period or (b) if the specified period spans two calendar years, that the payment will be made in the later calendar year, regardless, in either event, of when the release is signed (or any other required service provider action is taken).
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Arrangements that do not provide for payments to be made in a specified period following termination of employment can be amended to specify either (a) that the payment will be made on a fixed day following the termination of employment (e.g., the 60 th or 90 th day following termination of employment) or (b) that the payment will be made during a specified period (not longer than 90 days) after termination of employment, and if the specified period spans two calendar years, payment will be made in the later calendar year, regardless, in this clause (b), of when the release is signed (or any other required service provider action is taken).
In addition to amending the arrangement, the employer must attach a disclosure statement regarding the corrective amendment with its federal tax return for the year in which the arrangement is corrected. Only those arrangements in existence on or before December 31, 2010 are eligible for this transitional relief. If correction is made by December 31, 2012, the arrangement will comply with Section 409A with respect to the clause making payment contingent upon the action of the service provider.
As described above, the eligible arrangement generally must be corrected prior to the occurrence of the event triggering payment. However, there are two exceptions to this rule for arrangements in place as of December 31, 2010. No such arrangement (with a noncompliant contingency clause) will be treated as violating Section 409A with respect to any amounts paid on or before March 31, 2011. With respect to amounts paid after March 31, 2011, no such arrangement will be treated as violating Section 409A provided that (a) if the specified period for making the payment spans more than one calendar year, the payments are paid in the later calendar year, and (b) any remaining deferred amounts to be paid after December 31, 2012 (other than remaining installments or annuity payments that have already become payable) must be corrected (as described herein) on or before December 31, 2012. If payment described in clause (a) above is paid in the first calendar year, there will be a Section 409A operational failure.
If correction is permissible, all such arrangements of the employer and members of its controlled group, e.g., parents, 50% or more owned subsidiaries, etc., must be corrected.
For an arrangement with a noncompliant contingency clause that was not in existence on or before December 31, 2010, the transitional relief is not available.
What should be reviewed?
Taxpayers should review all arrangements subject to Section 409A to confirm they are structured properly where payment is conditioned upon some action by the service provider. This type of provision is typical in employment agreements, severance plans, change in control agreements and similar arrangements where payments are triggered upon the service provider’s termination of employment or other service.
What happens if the problem is ignored?
If correction is not completed by December 31, 2012 or the covered arrangement came into existence after December 31, 2010, then correction will need to be completed prior to the event which triggers payment of the compensation under the IRS’ general Section 409A correction program. In that case, correction would require the employer to provide additional disclosures to the service provider, and the service provider would have to include certain disclosures on his or her tax return for the year of correction. If the correction is not made prior to the event which triggers payment of the compensation, there will be a Section 409A violation. This means that the 20% additional tax will apply to the service provider, and the employer will be required to report the compensation in the service provider’s taxable income.
Call your Troutman Sanders LLP employee benefits attorney to determine if you have an issue and how it can be fixed.
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