Many US employers maintain arrangements that provide their employees with separation benefits upon involuntary termination of employment (severance arrangements). These severance arrangements can include, for example, severance and change in control plans and agreements, as well as employment agreements. Many severance arrangements provide that receipt of severance benefits will be contingent on the departing employee signing and not revoking a release of claims against the employer.

In order to satisfy the requirements applicable to the release of age discrimination claims, such releases often provide that the departing employee will be given at least 21 days (longer under certain circumstances) to consider whether to sign the release and seven days to revoke it after returning the signed release to the employer. The US Internal Revenue Service (IRS) has taken the position that, generally, to comply with US tax code section 409A (relating to nonqualified deferred compensation), a severance arrangement that conditions payments on a release must include a fixed date for the severance payment (as described below), and the departing employee must forfeit the severance benefits if the release does not become effective prior to the fixed date. Generally, a release is not effective until it is signed by the employee and the applicable revocation period has expired.

Delivery of Release

Because the release needs to be returned within a specified period after termination of employment, an employer should establish and maintain procedures to ensure that the release form is provided to the departing employee with adequate time for the employee to consider whether to sign and return the form. The time period should take into account any applicable revocation period following the execution date.

The form of release should conform to the requirements of the applicable severance arrangement. Often, the severance arrangement will have an attached release of claims form. If that is the case, then, generally, the attached form should be provided to the departing employee at or promptly after termination. If a release form is not attached to the severance arrangement, and the arrangement instead provides that the release will be in a form established by the employer at the time of the employee’s departure, it will generally be appropriate for the form of release to be prepared by the employer so that it is ready for prompt delivery at the time of the departure.

Time of Severance Distribution

Prior to the effective date of section 409A, many severance arrangements provided that payments would be made (or, in the case of installment payments, would commence) within a short period after the employee’s execution and return of the release. In Notice 2010-6 (Notice), issued earlier this year, the IRS took the position that this approach gave the employee impermissible discretion to delay or accelerate payment of severance benefits. This was the first time that the IRS published this position and some severance arrangements previously viewed as compliant with section 409A would now be noncompliant as a result of this position.

The Notice provides a procedure for modifying severance arrangements to conform to the IRS’s position. Under the Notice, no adverse consequences under section 409A will be imposed by reason of the above-described provision if (i) the arrangement is revised to remove the impermissible discretion before the employee’s separation from service, (ii) the revision is made by December 31, 2010, (iii) neither the employer nor the employee is under audit with respect to pertinent deferred compensation matters, (iv) both the employer and the employee attach statements to their tax returns for the year of the correction disclosing the occurrence of the revision, and (v) the employer takes commercially reasonable steps to correct similar provisions in all other deferred compensation plans maintained by the employer and its affiliates. Under some circumstances, it may be possible to adopt the revision without compliance with the foregoing requirements, by relying on the proposed regulations relating to the calculation of the amount of section 409A tax.

Failure to satisfy the requirements of section 409A can result in significant penalties. Accordingly, it will generally be appropriate for employers to review their severance arrangements (as well as any other arrangement that conditions payment of compensation on execution of a release or similar document) and their procedures with respect to releases, to determine whether those arrangements conform to section 409A, including the position announced by the IRS in the Notice.

If you would like more information about the foregoing, please contact the authors of this Legal Update, Debra B. Hoffman at +1 312 701 7219 and Wayne R. Luepker at +1 312 701 7197, or any other member of our Employment & Benefits and Executive Compensation practices.

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