Constructive Receipt of Severance Pay

[Christine Roberts]

Departing employee is to receive $250,000 in severance pay, to be paid over five years.

Because the severance pay is based on past service, and the money is nonforfeitable, wouldn't the entire $250,000 be includible in his gross compensation in the year of termination?

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[Guest Lorne Dauenhauer]

If the employee could have received the entire amount immediately, but negotiated that it be paid over a five year period, then it could be said that the employee 'turned his back' on the $250,000 and section 451 (constructive receipt) would require inclusion of the entire lump sum amount.

Otherwise, you'd probably have to look to the facts and circumstances surrounding the arrangement -- if the employer said 'that's the way it is' and the participant couldn't bargain for it, then constructive receipt might not apply.

Forfeitability is a different question (see Code section 83). If the company went bankrupt in year one, would the employee have a guarantee to receive the remaining payments as a secured creditor? If the money were put in trust with the employee being the beneficial owner, then this money would not be subject to substantial risk of forfeiture (and the entire amount would be included in his income). If the money is to be paid out of the corporate coffers, then you'd need to look at facts and circumstances to determine whether it is subject to a substantial risk of forfeiture.

If Code section 83 or 451 do not apply, then the severance payments would be taxable when received.

[Guest]

I suspect there is no constructive receipt problem.

My guess is that the employee was not entitled to the severance pay unless he signed a waiver or release of claims against the employer. This is SOP for most severance arrangements.

Thus, the employee was not entitled to anything until he signed the waiver. If the deferral election was made coincident or prior to signing the waiver, no constructive receipt occurs. The stream of payments was paid as the result of an arm's length negotiation and a surrender of rights (that is, the right to sue the employer).

I wouldn't worry about this . . .

[Guest CLKeown]

Christine -

You stated that "Because the severance pay is based on past service, and the money is nonforfeitable, wouldn't the entire $250,000 be includible in his gross compensation in the year of termination?"

No, the entire lump sum amount is does not need to be included in his gross compensation for the termination year.

Although the amount of severance is most likely calculated on a length of service basis it is not payment for services rendered during that time. Therefore you cannot say he "earned" the money during his last year of employment. Additionally, as Harry O. stated there is usually a requirement to sign severance agreements, confidentiality agreements, release of liablity, etc. If the severance agreement stipulates payments over a 5 year period then there is contractual basis for the arguement that the money is not "earned" until it is contractually due for payment.

It is similar to employment agreements that contain a commission or bonus guarantee. I have written employment agreements for example guaranteeing X dollars per year for 2 years, beginning in 2000. You do not include the entire bonus in the 2000 salary just because that is when the agreement was signed. As agreed the contractual obligation to pay the money is X dollars in 2000 and X dollars in 2001. Therefore no constructive receipt consequences exist.

Carole

[Guest Kurt]

If you are tallying votes, Lorne nailed the analysis and the facts may be such that $250K is includible in 2000 gross income.

[pjkoehler]

In general, "severance pay," unlike deferred compensation or retirement benefits, is a welfare benefit that compensates the employee for the loss of a job, rather than for the performance of services, regardless of the manner in which it is computed. So, you could argue that Code Sec. 83 (taxation of property transferred in connection with the performance of services) doesn't apply. But even if the benefit was for paid for the performance of services, Code Sec. 83 still wouldn't apply if the employer's benefit liabilty is merely an "unfunded and unsecured promise to pay money or property in the future," then Code Sec. 83 is inapplicable. Reg. Sec. 1.83-3(e). If the form of the severance pay (5-year payout) is hard coded in the plan document, then deferral is not an issue. So long as the employer avoids funding the benefit by setting aside funds that are beyond the reach of its general creditors, the constructive receipt principles of Code Sec. 451 do not operate to accelerate taxation in a tax year prior the year of actual receipt.

[BeckyMiller]

Is this a for-profit or a not-for-profit entity? If not-for-profit, Section 457 might give you trouble if the award was not considered bona fide severance, but actually deferred compensation.

[Christine Roberts]

It is a non-profit entity.

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[Guest]

For what purpose are you asking---plan contributions or W2 reporting. I would include it in W2 each year.

[BeckyMiller]

As a non-profit employer, you have to look to the special rules of Sectin 457 which supercede in some respects the more general discussion of constructive receipt. The good news is that a bona fide severance pay plan would stay within the guidance discussed above.

In determining whether or not the arrangement is bona fide, some insight (though not a final determination) can be found in a recent IRS pronouncement, Announcement 2000-1. You should check the bulletin board message stream from Carol Calhoun on this notice for more information.

[This message has been edited by BeckyMiller (edited 04-07-2000).]

[This message has been edited by BeckyMiller (edited 04-07-2000).]