As the end of the year approaches, important transition relief from penalties and excise taxes imposed by Section 409A of the Internal Revenue Code (the Code) is about to expire. If an employer has an employment agreement or other nonqualified deferred compensation plan that provides for severance payments to an employee only if such employee executes a release, there may be a technical violation of Code Section 409A. The Internal Revenue Service allows for correction of such technical violations without penalty, but the correction must occur before December 31, 2012.

In 2010, the IRS issued two notices (IRS Notice 2010-6 and 2010-80) addressing how to fix an employment agreement that was not in compliance with Code Section 409A. In these notices, the IRS stated that by allowing an employee to receive his or her severance payment following the execution of a release, the employee would be able to control the year of such payment by timing when he or she delivered such release to his or her employer. The IRS stated that, to the extent the severance payment is subject to Code Section 409A, the ability to control payment timing is a violation regardless of whether the execution and delivery of the release actually crosses two taxable years.

The IRS provided transitional relief from this technical violation by allowing employers to amend any noncompliant employment agreement or other nonqualified deferred compensation plan in effect as of December 31, 2010. Under the transitional relief, such agreement or plan must comply with the Code Section 409A release requirements by December 31, 2012.

In order to take advantage of the transitional relief, an employer must correct the noncompliant agreement or plan in one of two approved manners and include the names of the employees affected and the correction method used by the employer.

Briefly, if the agreement or plan provides for a defined payment period, the correction must be made to provide for either: (a) payment only on the last day of such defined period or (b) if the defined payment period begins in one taxable year and ends in another taxable year, payment must be made in the later taxable year. If the agreement or plan does not provide for a defined payment period, the correction must be made to provide for either: (x) payment only on a specified date either 60 or 90 days following the employee’s separation from service, or (y) payment during a defined period not longer than 90 days following the employee’s separation from service, except that the payment must be made in the later taxable year if that period could span two taxable years.

If the agreement or plan is not corrected by the December 31, 2012 deadline, payments made pursuant to such agreement or plan may be immediately included in an affected employee’s income, a 20 percent penalty tax will be imposed, and additional interest taxes may apply. Please note that in the case of a bilateral agreement or plan, the affected employee’s consent is required to make any change, so employers should allow plenty of time to make these corrections.

A copy of IRS Notice 2010-6 can be found here and a copy of IRS Notice 2010-80 can be found here.