Section 409A Broadly Impacts Employment Agreements, Severance Arrangements And Settlement Agreements.

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Section 409A Broadly Impacts Employment Agreements, Severance Arrangements And Settlement Agreements.

Many employment law attorneys and human resource professionals are surprised to learn that section 409A of the Internal Revenue Code ("Section 409A"), which was enacted to curb abuses related to deferred pay arrangements for high-ranking executives, also impacts arrangements that defer pay only incidentally and arrangements that are broad based across an employee population. This Insight discusses how Section 409A affects employment agreements, severance arrangements and settlement agreements, how employers can utilize exceptions built into the rules to sidestep the restrictions imposed by Section 409A and the necessary steps that employers must implement in order to comply with these rules.

What Does Section 409A Regulate?

Section 409A essentially regulates any arrangement that defers compensation. Simply put, a deferral of compensation exists if a service provider (generally an employee) obtains a "legally binding right" to compensation in one year that is then paid in a later year. A legally binding right exists even if the payment of the compensation is conditioned on the future performance of services or other conditions established by the employer (such as a financial goal of the employer being met). There is no deferral of compensation, however, where an employer has an unfettered right to reduce or eliminate the compensation.

Deferred compensation can thus be created in many ways under employment agreements, severance arrangements and settlement agreements. Under an employment agreement there may be a promise to pay an employee a certain sum if he or she works for an employer for a requisite period or if a financial goal is met. A severance plan or other agreement may provide for the payment of a certain amount in the event that certain events transpire. Similarly, a severance deal or an agreement to settle a lawsuit, which is negotiated with an employee upon his or her departure, may create deferred compensation if payments are made beyond the current calendar year. Therefore, employment lawyers and human resources professi...

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