The Issue: An employment agreement conditions severance payments to an executive on her signing a release. Can this create a tax problem for the executive under the non-qualified deferred compensation rules of the Internal Revenue Code?

The Solution: Yes, unless the provisions of the employment agreement are properly drafted and the parties comply with the terms of the agreement.

Analysis: Code Section 409A (409A) governs the terms and operation of “non-qualified deferred compensation plans” and imposes restrictions on the reasons for and timing of deferred payments.  Neither the employee nor the employer may accelerate or defer the receipt of deferred compensation (with some exceptions not applicable here).

Failure to comply with 409A leads to serious tax consequences for the executive, including acceleration of income and a 20% tax penalty.  California imposes its own 5% tax penalty for failure to comply with 409A.

Termination of employment is a permissible payment event.  If the employment agreement provides that severance will be paid within 2-1/2 months after termination with no conditions, the payment isn’t subject to 409A.  If the  agreement provides for a series of payments equal to not more than twice the executive’s pay (or the qualified plan compensation limit, currently $260,000) and they are to be paid within two years after termination, there is no problem.

The concern with conditioning severance pay on an executive signing a release is that if there is no time limit on when the release must be signed, the employee can affect the timing of payment by either signing the release quickly or delaying to a later date.  This violates the strict requirements of 409A.  It is important to recognize that it is not the employee’s action or inaction that is the problem; it is the provision in the employment agreement.

The remedy is simple.  The employment agreement must specify (or be amended to specify) a fixed payment date after termination of employment (either 60 or 90 days) or a specified period no longer than 90 days when the severance payment will be made or commence (with special rules if the payment period can go into another tax
year).  If the executive fails to sign and return the release by the commencement date, the severance must be forfeited.

Employers should tread carefully when dealing with the complicated requirements of 409A.  If an employment agreement provides for any post-termination payment, it should be reviewed for compliance with 409A.