October 2005

IRS proposes new rules on severance pay

If you terminate an employee and pay severance, the pay may not be eligible for deferment into a 401(k), 403(b) or a 457 plan, says John-Edward Alley, of Ford & Harrison, labor-law attorneys. The Internal Revenue Service has issued proposed regulations indicating which types of “severance” should be taxed and which should be paid tax-free.

The proposed regulations provide that amounts received by an employee following his or her “severance from employment” may not be deferred unless the amounts are considered compensation under Code Section 415. Compensation, under IRS definition, includes amount paid within 2-1/2 months after termination for:

• Services performed while an employee, but not paid until after the employment relationship ended, and

• Payments for accrued sick, vacation, or other leave that the employee would have been able to use if the employment relationship had continued.

The IRS rule does not apply to amounts paid to a former employee engaged in qualified military service that are not in excess of compensation s/he would have received had s/he not entered the service.

Amounts that are separation pay or payments pursuant to an ERISA severance pay plan (for example, amounts paid to a terminating employee to compensate the employee for an unexpected job loss), unfunded nonqualified deferred compensation, or parachute payments are not considered compensation by the IRS and cannot be put into deferred-payment plans.

The proposed regulations are anticipated to be effective for limitation years beginning on or after January 1, 2007, but may be relied upon pending issuance of final regulations.

“Severance pay” is a term defined by the IRS, says Alley. “We recommend that our clients not use the terms severance pay or severance agreements in the absence of a true written ERISA severance pay plan …Rather, it is our recommendation, where an employer provides a sum of money on separation to the departing employee in exchange for a separation agreement, including a full and complete release of all claims and generally, non-disparagement, confidentiality, and sometimes other terms, that you continue to refer to this as separation pay or a separation agreement rather than ‘severance pay.’

Source: John-Edward Alley, Ford & Harrison, www.fordharrison.com

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