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Avoiding spectacular tax problems for employee separation pay
It is a common practice for employers to require terminating employees to execute a release of claims in exchange for designated separation pay. Compliance with esoteric tax rules governing the payment of deferred compensation is typically far from the minds of the decision makers during the termination process.
The Internal Revenue Code, however, has laid a trap for the unwary.
Section 409A, while aimed at preventing manipulation of deferred compensation arrangements to artificially delay payment of executive income tax liabilities, has unfortunate and complex interactions with the release/severance process.
Section 409A of the IRS Code is broadly applicable to compensation arrangements that are outside of the qualified plan area. There are a number of exceptions to its application, the most useful of which is for so-called "short-term deferral".
"Short term" in this context means compensation that is paid within two and a half months after the end of the year in which the services giving rise to the compensation is paid, or March 15 of the year in which the services are rendered in most circumstances.
While actual payment during that period is a helpful fact, the IRS position is that the arrangement must require that result in order for the short-term deferral exception to be applicable to severance payments.
Many practitioners disagree with the IRS’s position here, but picking a fight over the issue is better avoided if at all possible.
The IRS position is predicated upon the concern that, to the extent that a severance payment is contingent upon the terminating employee executing a release, or contingent upon the expiration of a set period that the execution of a release sets in motion — such as the ADEA waiver period — the terminating employee could take advantage of that timing to improperly designate the year of payment.
By doing so, the employee could thereby impermissibly control the timing of the income tax liability resulting from the payment.
In the real world, concern about terminating employees manipulating the timing of income tax liabilities seems far-fetched. However, in the IRS-world, this concern is real, which creates issues for employers.
There are several alternatives for employers in structuring compliant separation agreements that provide for both the releases and severance payments.
The key point is to provide in the severance agreement that the payment will be made on a specified date, or within a period chosen by the employer, rather than at a time controlled by the employee, such as upon his or her execution of the severance agreement, or within a certain number of days following execution of the severance agreement.
The above-referenced approach is fine for agreements now being negotiated or that arise in the future by employers aware of the issue.
But what about existing agreements that provide for the payment to be made upon the terminated employee's execution of the severance agreement, or upon the expiration of the ADEA waiver period thereafter?
In such cases, the IRS has published certain specific procedures in Notices 2010-6 and 2010-80 for resolving non-compliant arrangements without causing a tax disaster for the severing employee.
Utilization of those techniques, while burdensome, should eliminate the 20 percent penalty applicable generally to 409A failures in favor of acceleration of recognition of the relevant income tax applicable to the severance payment in an earlier taxable year.
The adoption of section 409A by Congress has led to many unintended consequences and complexities. The release issue adds one more hoop for employers to jump through, but can be relatively easily complied with by employers and advisers who are aware of the potential pitfalls of a non-compliant arrangement.
Thomas Bergh is a partner with Varnum LLP.