An Oldie but Goodie: severance pay as a source of 401(k) deferrals

[Guest erisafried]

At this point, we all know that the IRS frowns upon deferrals made from post-termination payments (e.g., severance, bonuses, commissions) by departing employees. In some of the IRS's informal comments, I get the impression that we are talking about a bright line (i.e., if an amount is paid even one millisecond after an individual is "terminated" -- whenever that is -- no deferrals can be made from it, even if it was clearly earned prior to termination) and in some other comments, there seems to be a recognition that an amount earned prior to termination but paid within a short time thereafter might still be an acceptable source of deferrals.

What I am wondering is whether the following scenario would be within the realm of reasonableness:

Employee A terminates on April 10 and receives a check on April 15 as part of the normal payroll process; this check includes only regular wages. Employee A signs the standard release of claims on April 14 and therefore becomes entitled to receive a severance benefit; because of the timing, the severance benefit cannot be paid until the April 30 payroll. On April 20, the accounting department finishes up its review of Employee A's sales through April 10 and concludes that he has some commissions coming, also to be paid on the April 30 payroll. For what it's worth, Employee A's health insurance as an active employee runs through April 30.

I think that we are fairly safe in allowing deferrals from the April 15 check. What about from the April 30 check? If we were talking about a commission or bonus check paid in June, that would clearly be out of bounds, but what if the check is paid during the month of termination? What if the company regards Employee A as an active employee through the end of April (even though he doesn't come to work after April 10)?

Any thoughts?

[Guest KB]

If you have a plan document with language that allows deferrals from compensation that was earned by the participant while an employee (especially if you also have a determination letter), why wouldn't the employee be allowed to defer from the April and June bonus?

At my former job, our plan (that had a favorable d-ltr) allowed deferrals on any 401k-eligible comp that was paid to the employee, regardless of when it was paid after term date. Often commission-only employees receive trailing pay months after their term date that is otherwise 401k-eligible. It can sometimes be administratively difficult to shut off deferrals on terms (timing issues).

The other side of this, though, can be that an "outer" limit could be set, such as 45-60 days after term date, where deferrals could be turned off (set to 0%). It becomes hard to explain to a participant terminated for, say, 6 months that a small, residual deferral was allocated and that the participant needs to request another distribution.

In the end, it depends on what is allowed in the document.

[Harwood]

IRS thinking; not definitive:

http://www.asppa.org/archivepages/gac/1999/99irsq&a.htm

67. What is the IRS position on elective deferrals from certain payments following the termination of employment, such as severance pay, accumulated vacation pay, and bonuses?

These payments are not eligible to have any part of them deferred under 401(k) since the participant MUST be an employee in order to defer and the employment relationship has ended prior to the payment of these amounts.

[Guest erisafried]

The problem I've got with the IRS pronouncement on this issue is that they all ultimately involve the metaphysical question of when some is or is not "employed." Often, this question is easy to answer because someone obviously is still an employee...or obviously is not.

If the IRS sticks to its regulatory plan, it is supposed to be issuing some formal (yay! something we can rely on!) guidance in this area in 2005. I'll just hold my breath until then....

[Kirk Maldonado]

The informal IRS position that is cited above produces absurd results in some circumstances, as illustrated by this example.

Assume that individual K works for an employer that pays all of its employees on Friday for the work that they did that week. Individual M works for a different employer that pays employees on Wednesday for the work that they did in the preceding week. Assume further that both K and M quit on Friday and want section 401(k) contributions taken out of their final paychecks.

K would have section 401(k) contributions taken out of his last paycheck, because it is paid to him while he is still employed. M could not have section 401(k) contributions taken out of his last paycheck, because it is paid to following termination of employment (on Wednesday of the following week).

Thus, under the IRS position, whether section 401(k) contributions can be taken out of a participant's final paycheck depends on when the paycheck is delivered. I can't come up with a policy that justifies that result.

[rcline46]

Kirk, the answer to your question lies in tweaking your example just a bit -

Calendar year plan, change Friday to December 31. The second person receives a next year contribution. Now when it comes to testing you have a 'non employee' with a deferral and comp in the next year testing. The IRS has stated that this person is not in the testing because they were never eligible in the following year.

[Kirk Maldonado]

rcline46:

Can't you overcome that problem by skillful plan drafting?

[rcline46]

I doubt it. Problem 1 is that the person is on all reports (think daily val!). Problem 2 is that the TPA has information and must manually make decisions no matter what the document says. Problem 3 is the large number of institutional prototypes and IDPs NOT skillfully written.

That is why I agree - terminated? Stop deferrals automatically.

[Harwood]

How to Treat Severance Pay for Purposes of Salary Deferral Contributions and Discrimination Testing

http://www.jenkens.com/jenkens/newsletters/BIB/bib_v3i2.pdf

Eligible Deferral Wages

http://www.reish.com/practice_areas/Techni...ps/IRStip85.cfm

[Guest erisafried]

Just to stir the pot a bit more, I was talking to a colleague, and she mentioned that at a recent conference, a couple of IRS representatives got into an argument (on stage!) about this point, one taking a stricter line and the other adopting a more moderate approach. I suppose this is why we don't have crystal clear guidance.