Separation from service under 409A

Defining “Separation from Service” under Section 409A

Fulcrum Partners. Deferred Compensation News

The atypical circumstances of recent months have created new situations most organizations have not previously faced. Every employer needs a clear understanding of which workforce reduction circumstances could constitute a “separation of service” and thereby trigger payment of benefits for plan participants covered by a nonqualified deferred compensation agreement (NQDC). 

Understanding Separation of Service 

Sick leave or a bona fide leave of absence of six months or less does not establish a separation from service. Nor is there a separation from service if the sick leave or other bona fide leave is longer than six months but there is a reasonable expectation that the employee will return to work for the employer. “Reasonable expectation” can be defined either by a contractual or statutory right to reemployment. The FMLA (Family and Medical Leave Act) is one example of such a statutory right.

Likewise, a furlough does not typically qualify as a separation of service as long as the employer and employee reasonably anticipate that the employee will return to work and that upon returning, the level of services to be performed by the employee after such date would not be permanently reduced to 20 percent  or less of the average services rendered by the employee during the immediately preceding 36-month period (or the total period of employment, if less than 36 months), disregarding periods during which the employee was on a bona fide leave of absence.

An employee could even be terminated, and the criteria for separation of service still not be met, if the employer and employee reasonably expect the employee will be rehired. 

Thorough Evaluation of Your Company’s Situation

Throughout the COVID-19 pandemic, employers have searched for ways to retain their valued employees while remaining stable as a company. Organizations have deployed various workforce strategies or combinations of strategies, including layoffs, furloughs, hourly reductions, and terminations. 

While inadvertently triggering a payment event could seem like a windfall to a plan participant whose income has been temporarily reduced or eliminated because of COVID-19, Tax Code 409A tightly regulates the timing and form of plan payouts. Evaluation with your tax, legal, and executive compensation advisors will help your company understand how actions taken in recent months impact your organization’s NQDC plans and employee plan participants. In the event of a misstep and resulting 409A noncompliance, the plan participant could be facing both income taxes and a potential 20 percent IRS penalty.

You may also be interested in this related article: Fulcrum Partners Releases Report on Impact of SECURE Act on NQDC Plans and Important Strategic Tax-Saving Solutions

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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

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