Severance and 409A

[Randy Watson]

An employee's monthly severance compensation is based, in part, on collections (attributable to the employee's services) that the employer receives after the employee terminates employment. It has been suggested to me that this "severance" is not deferred compensation for 409A purposes since there is no legally binding right to the collections and thus no legally binding right to the severance.

For example, assume Employee A works for Consulting Firm. Employee A provides consulting services for a client of Consulting Firm and the client is charged a fee in January 2005. Employee then terminates employment the next month. Client decides NOT to pay the fee and Employee A receives no severance as a result (no collections after termination=no severance pay). The bottom line is that the severance was "unilaterally reduced or eliminated by....[an]other person after the services creating the right to the compensation have been performed." Q&A 4 of Notice 2005-1. Therefore, there is no legally binding right and no deferred compensation.

Any comments? Bad analysis?

[QDROphile]

What kind of business lets its clients unilaterally decide whether or not to pay fees for services rendered? Something seems wrong with the picture.

The agreement could be a binding right to receive payments based on collections. It may be that there are no collections or irregular collections, but I would expect a least an implied term for reasonable good faith collection efforts.

There could be other aspects of the arrangement that would make it either not covered by 409A or compliant with 409A. What is the compliance problem that concerns you?

[TCWalker]

Perhaps a bad analysis in the respect wages may be imputed in your hypo.

Your "in part " reservation seems to imply it's not entirely speculative or contingent, but taken on its face I don't see that a legally binding right to receive compensation exists until the collection is successful.

[Just Me]

I believe the Treasury Department spokespeople have been very clear that a legally binding right may be contingent in nature. In other words, if X happens, you will receive Y. Looks like if clients pay the fees, the former employee gets paid, therefore I would suspect you have a legally binding (albeit contingent) right in this situation.

[Randy Watson]

From Tax Management Roundtable Discussion:

MS. WALKER: The next question, Question 15, goes to an employment agreement that provides for payments based on productivity. Actually the amounts are paid upon termination of employment, but paid over a 12-month period. Is this 12-month payment a deferral of compensation after I finished rendering services?

MR. HOGANS: Possibly not. I think that here it's specified that they'll be paid out as billings are collected. If the collection of the billings is a condition of the payment, I think there's a question. I think if payment is certain and they're wholly unrelated, and there's no real risk of forfeiture, and there is no material condition, then, possibly yes. So I think it really depends on the facts.

MR. MISNER: It might not even be a legally binding right if it's tied to them getting paid, right? I don't know if that's a nuance, or if that's in line with your conclusion.

MR. BOSTICK: I suppose things like insurance renewal commissions would be a good example of this kind of situation. I may have terminated my agency relationship with the insurance carrier but the business I've written is going to continue to pay me some commissions to the extent it remains in force for some period of time. And that's part of the deal, it was in the contract and it can't be cut off. But it is definitely contingent on something happening.

MR. HOGANS: Yes. This is something I think we're thinking about and this would be a fairly factual determination. And it may be that, in the insurance context, that the likelihood of renewal is sufficiently high that the condition is not a substantial condition.

MR. LEWIS: That's not likely to be the case based on overall statistics. It seems to me, your previous analysis that it's a legally binding right, but it's not vested, may be the same answer.

MR. BOSTICK: And it might.

MR. HOGANS: It might be. I'm just saying it might not be. We're still looking at that.

MR. LEWIS: If you start deciding vesting on percentages, for example, 90%, that's going to be a tough road.

MR. BOSTICK: It's going to be hard for people to draw the lines here.

MS. WALKER: And I think when you're thinking about this, you want to look at the interplay of the six-month rule for termination of employment and the fact that this really is only 12 months. These things don't go on forever. They're a limited period.