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Client Alert: Employment & Compensation Agreements Require Attention Before Year-End

Prior to year-end, employers should review all employment, severance, and change in control agreements (as well as other compensation arrangements) that condition payment on the employee’s execution of a release of claims or other employment-related obligation (e.g., post-employment restrictive covenants).  Amendments may be required prior to December 31, 2012.

Possible Code Section 409A Violation


Intentional Delay of Payment.  The Internal Revenue Service has indicated (in Notice 2010-80) that it is concerned that an employee could use the execution of a release of claims (or the execution of another employment-related obligation such as a post-employment restrictive covenant) to manipulate the timing of payment of deferred compensation.  For example, if an employee is entitled under an employment agreement to an amount of severance that is contingent upon the employee’s execution of a release of claims, then the employee may be able to delay executing the release until a date on which he or she wants to receive the amount of severance (for example, into the next tax year).

Specified Payment Date.  The IRS has indicated that any such employment-related obligation must have a definite time period attached to it so that payment will always occur on a specified date.  In other words, an open-ended approach of simply requiring a release of claims (or execution of other employment-related obligation) in exchange for the severance payment will not be sufficient in most cases.  One acceptable manner for dealing with this issue would be to include a provision stating that, following a termination of employment, an employee will have 60 days to sign a release, and if he or she does so, the payment of severance will be due to him or her upon that 60th day.

New Rule Not in Regulations.  The existing regulations under Code Section 409A do not include a similar rule.  Therefore, it is possible that agreements drafted, or amended, to comply with the Code will fail to satisfy the IRS’s position.

Consequences of Failing to Amend


If an agreement contains an “open-ended” employment-related obligation at the time payment is due, the agreement will be deemed to violate Code Section 409A and the employee may be subject to an additional 20 percent income tax (plus, if applicable, interest and penalties).  An amendment prior to December 31, 2012, should serve to avoid these consequences.
 

Compliance Deadline


Compensation arrangements that condition the receipt of any amounts on the execution of a release of claims or other employment-related obligation (e.g., post-employment restrictive covenants) should be amended before December 31, 2012, to comply with the IRS’s position as described above.  Employers should review all employment, severance, and change in control agreements (as well as other compensation arrangements) to determine which, if any, will require such amendment.

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