Internal Revenue Code Section 409A

What’s Code Section 409A? Congress enacted Internal Revenue Code (“Code”) Section 409A (“Section 409A”) as part of the American Jobs Creation Act of 2004 which generally was effective on January 1, 2005. Between 2005 and December 31, 2008, compliance with Section 409A generally required compliance with interim Internal Revenue Service (“IRS”) guidance and a reasonable, good faith interpretation of Section 409A. However, effective January 1, 2009, Final Regulations issued by the Treasury Department require strict compliance with the approximate 400 pages of guidance.

Why should we care about Section 409A? Employees need to be aware of Section 409A in structuring and negotiating employment and severance agreements because violations cause the imposition of significant penalties. In general, Section 409A applies whenever an employee has a legally binding right to compensation that is not payable until a later year. An employee does not have a legally binding right to compensation if the employer may unilaterally reduce or eliminate the compensation after the services creating the right have been performed. Notwithstanding that, a right to compensation subject to a contingency, such as termination for other than cause, will still constitute a legally binding right.

What happens if Section 409A applies to my severance agreement and are there any exceptions? If Section 409A applies, certain requirements must be met and, if they are not, the employee faces significant penalties. Fortunately, Section 409A provides an exception for certain severance arrangements, as severance paid pursuant to an involuntarily termination, a termination for good reason or a window program is not subject to Section 409A to the extent that the severance pay meets certain requirements relating to the timing and amount of the payment. In addition, severance pay may be structured to meet another Section 409A exception known as the “short-term deferral rule” whereby payment is completed within a certain amount of time following the year in which the termination occurs. Accordingly, it is incumbent on any employee to negotiating a severance agreement to retain counsel that can identify the issues and assist in crafting the agreement to either comply with or fit within the purview of Section 409A’s exception.

What are the finer negotiation points? There are several, but let’s focus on the negotiation to obtain the employer’s payment of any Section 409A penalties. While employers are not directly subject to penalties for violations of Section 409A, some employers may decide to pay Section 409A penalties, in part, to keep their employees happy and, in part, because the employer is often the party responsible for drafting the documents that caused the violation. In addition, employers that negotiate severance pay upfront, with the purpose of attracting an employee or softening the blow of termination are, often undermined by the tax penalties associated with arrangements that violate Section 409A.

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