Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections. This is the first of those posts.
You are designing an executive employment agreement with a substantial severance component. For the amount of severance, it seems fair to condition payment upon execution of an agreement waiving all employment claims (ADA, age discrimination, etc.). Why not just say that severance payments don’t begin until the executive returns the claims release? The answer – Code Section 409A.
Incredulous? Here’s the concern. An employee who will begin to receive severance upon return of a release could potentially hold on to the release until the year following his or her termination. What does that achieve? Because the severance is taxable when actually paid, the employee could hold on to a release, defer taxation, and ultimately pay fewer taxes on the severance. Employee discretion as to the timing of taxation exercised opportunistically upon termination of employment is anathema to Code Section 409A.
There are two common solutions to this design problem, both with advantages and disadvantages. First, payment could begin upon a fixed cut-off date, 60 days for example, following termination of employment if the claims release becomes effective before that date. This solution is easy to administer, but doesn’t necessarily get severance to the employee as quickly as the employee would like.
Alternatively, the employment agreement could call for severance to begin upon return of the employment claims release within a fixed window (90 days maximum) following termination of employment. However, in order to preclude the employee from holding on to the release to affect the year the severance is taxable the agreement would need to provide that if the window period straddles two calendar years, payment will be made no earlier than the first day of the second calendar year. For a December termination in an agreement with a 90 day window, this would mean payment couldn’t begin before January 1 of the second calendar year regardless of when the employee returned the release. This approach is potentially more palatable for the employee, but adds to administrative complexity.
So what if you have an existing employment agreement with severance beginning upon the return of an uncapped claims release? Assuming you follow certain formalities, the IRS permits correction under Notice 2010-6, its Code Section 409A documentary correction program. Generally, in addition to satisfying the Notice 2010-6 formalities, correcting requires amending the employment agreement to implement one of the two strategies described above. However, if the agreement does not already cap the period for the return of an employment claims release, the IRS requires the use of either a 60 or 90 day period if the agreement will use the first strategy going forward.