Consulting Agreements as deferred compensation

[Guest Richard Tennenbaum]

I've come across an employment agreement in which the employer agrees to hire an employee on a consulting basis after 'active employment' ends. The payments for the consulting work will be bi-weekly or monthly and they will be a % of the employee's average pay during the last 3 years of active employment. At first blush, it looks like a simple agreement to keep a valued former employee's knowledge with the company. I don't see a deferral of compensation. The former employee will be paid as the contract calls for and may be terminated at anytime.

However, the new 409A regs lead me to believe that the Service would consider the agreement to be a deferral of compensation; though it's not entirely clear.

I'm guessing that termination of the agreement will not lead to penalties, so long as nothing is paid out as a result of the termination. What about payments that have been made to current 'consultants'?

I'm not sure what to do here....

[E as in ERISA]

It's most likely to be deferred compensation if the payments are not commensurate with the service. If they get $X bi-weekly or monthly even when they haven't done anything, then those might be recharacterized compensation for prior services. Then you need to look at the timing to see if it meets any exceptions or requirements.

[JDuns]

As described by E, this is most likely deferred comp under 409A.

If the contract is terminated before 12/31/05, even if an amount is paid, there would be no penalty due to 409A.

In addition, if the individual was fully vested and had terminated as an employee before 1/1/2005, I think you could argue that the grandfather rule applies so that 409A does not apply.

[Guest Richard Tennenbaum]

Thanks for the replies.

As I read the new Regs., I believe that a case could be made that even though 409A might apply, the agreement(s) meet the various statutory requirements that the 'plan' must be written, and the form and time of payments must be defined. If that's the case, then, though 409A would apply, there would be no penalties assessed...the 'consultants' pay taxes upon the amounts 'earned' throughout the consulting agreement.

Outside of the plan being 'written', payments may not be accelerated, and the timing of payments must be defined, what othe requirements would need to be in the consulting agreements? (disclaimer: I'm not being lazy; just came up again and I'm under the gun...any good, succint resources you might recommend on the new regs.? if you don't want to spell out the other requirements?)....

Thanks all....

[E as in ERISA]

I think that the rule of thumb I've generally heard is same as what you've said. If time of payment is specified, you're probably in good shape.

[Guest Richard Tennenbaum]

I believe the last 'rub' that I'm going to be worried about is the reporting requirements from Notice 2005-1. Assuming that the plan is acceptable pursuant to the regs (written, specific time of payment), I believe that until further guidance we are to rely upon the Notice for current reporting (See Q-24/25 of the Notice).

Given that there isn't a determinable amount in each year before the consulting period begins, I'm not sure what, if any, amount could be reported.

How troubling...

[E as in ERISA]

I haven't looked. Would that just be something like a $25 W-2 reporting violation or would it potentially be a 409A violation?

[Guest Richard Tennenbaum]

I think it would just be a W-2 reporting violation (and depending on the timing of the corrected W-2, it would probably be $50 per W-2. So if I'm only dealing with 5 agreements,....not too bad...

I just don't see anything that would lead me to believe that it would cause a 409A plan failure...especially since Notice 2005-1, Q-25 states that further guidance will be issued on calculating amounts deferred for reporting purposes and that guidance hasn't been issued as of yet. I'm not sure there is a reasonable way as of yet to ascertain the deferral amount in a 'salary continuation'-type plan that a consulting agreement might be considered. Especially if the payments were say based on the last 2 years of employment...how could you determine that 5-10 years before the last 2 years of employment...

I think my best bet is to make sure the agreements meet the 409A requirements and not report on a W-2 until there is further guidance...risking the $50 per W-2 penalty....

Thanks for your comments...any continued insight is welcomed...

Richie

[TCWalker]

I'll be the sole dissenter, I think it's service contract income - nothing deferred. It seems rational to me to base the contract rate on a % of prior compensation as a benckmark, as long as the service contract performance by the payee isn't a sham.

[Guest KLCarter]

Do I understand that this agreement can be terminated at any time? If so, I think that these amounts are not earned and vested, and therefore do not fall under the definition of deferred compensation. Am I missing something?