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409A Deadline Requires Employer Action by December 31, 2012

September 19, 2012

The language in many employment, severance, change-in-control or similar agreements that provide for severance payments to employees has the potential to violate Section 409A of the Internal Revenue Code. Employers now have until December 31, 2012 to amend such agreements to protect their employees from certain taxes and penalties imposed by Section 409A.

By way of background, an employer frequently conditions the payment of severance to an employee upon the execution and non-revocation of a separation agreement and release of claims. If the severance can be paid in a year following the year in which the employment relationship ends, all or some portion of the severance may be considered “deferred compensation” by the IRS.

Deferring the payment of severance frequently serves an important business purpose for an employer – incentivizing an employee to comply with post-employment non-competition, non-solicitation and other restrictions for a longer period. This business purpose may have the effect, however, of exposing the employee to current federal income taxation and a 20% penalty tax under Section 409A. In particular, the IRS views an employee’s potential to affect the year in which severance payments will be made (by exercising discretion over when to execute a separation agreement and release) as a violation of Section 409A.

In 2010, the IRS adopted, as part of a broader 409A document correction program, a set of rules designed to bring the timing of severance payments into compliance with 409A. If agreements are in compliance by December 31, 2012, then, under the transition relief, the employee is not subject to 409A taxes and penalties. (However, the employer is required to attach certain information to its tax return disclosing the corrections.)

The correction methods differ depending upon whether the employment, severance, change-in-control or similar agreement already specifies a period of time after the termination of employment within which the severance payments will commence. Because the Section 409A taxes and penalties can be draconian, an employer should consider availing itself of this program as a means of protecting its employees – especially its executives. Accordingly, it is important for an employer to enlist the assistance of counsel in reviewing compliance with 409A and, if necessary, in amending agreements to ensure compliance.

For more information or assistance, please contact:
Adam B. Cantor | Chair, Employee Benefits and Executive Compensation Group | (973) 530-2020 |
Farah N. Ansari | Associate | (973) 530-2044 |