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Grandfathered deferred comp - When does an Independent contractor terminate? [Updated]


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Has anyone seen guidance regarding paying out grandfathered deferred comp when the employee who deferred the compensation becomes an independent contractor?

Per Section 1.409A-1(h)(ii) of the 409A regs, an employee is not considered to have a separation from service if he or she shifts from employee status to independent contractor status.

A client has a grandfathered 2003 deferred compensation agreement.  The executive deferred the compensation until "Retirement," which has a rather loose definition.  If the plan committee finds that the employee has had a cessation of services to the company that is deemed to constitute a retirement, then he has retired. 

The executive has scaled back his work level, is retirement age, and is ready to retire.  The employer would like him to remain a consultant for a few years, likely working much less that he was as an employee.  Both parties would like to treat him as retired for purposes of the deferred comp agreement.

It seems the 409A concept of separation from service should not be applicable.  I am rusty on my pre-409A deferred comp payment triggers and whether there is a well-defined concept of separation from service (I have not found one in any event).  If in his new role he is truly a contractor as opposed to a common law employee, I believe he can reasonably be deemed to have retired and should be paid the deferred compensation that was deferred until his "retirement.'

Thanks in advance for any thoughts.

UPDATE - Edited for revised facts:

I received updated facts.  Turns out the individual was already an independent contractor when he made the original deferral in 2003.  He remains an independent contractor but will soon enter into a new agreement for a much lower payment and will be "significantly less active."  Though 409A does not apply, it would state that the individual does not terminate until there is an "expiration of the contract" and a "good faith and complete termination of the contractual relationship." § 1.409A-1(h)(ii)(2).

In the pre-409A landscape I could not find a definition of separation from service.  Even in the qualified plan space, there is no real concept of making distributions upon shifting to part-time status.  Also, contractors do not report the amount of hours or work done to the service recipient - they merely do requested tasks.  As such, it seems risky even in a non-409A world to deem a contractor to have "retired" and make a payment of deferred compensation based on a mere reduction in the scope of services under a new agreement.

Finally, what if the company pays out the deferred comp without an expiration of the contract and the IRS disagrees that there was a "retirement." Would 409A become applicable, with the IRS perhaps arguing that the company had made a "material modification" to the agreement, by adding a new distribution trigger (payment despite no cessation of services)?  The parties would have failed to follow the terms of a grandfathered plan and the failure would result in a material change to the payment timing.

Thanks again for any thoughts!

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  • FAQ changed the title to Grandfathered deferred comp - When does an Independent contractor terminate? [Updated]

There was no objective definition of retirement, separation from service, or termination of employment before 409A.

On 6/16/2022 at 12:59 PM, FAQ said:

Finally, what if the company pays out the deferred comp without an expiration of the contract and the IRS disagrees that there was a "retirement." Would 409A become applicable, with the IRS perhaps arguing that the company had made a "material modification" to the agreement, by adding a new distribution trigger (payment despite no cessation of services)?  The parties would have failed to follow the terms of a grandfathered plan and the failure would result in a material change to the payment timing.

Seems to me you've found a valid issue to be concerned with FAQ. The actual answer for your situation will depend on all the facts and circumstances.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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