July 7, 2016
Authored by: Chris Rylands and Katharine Finley
On the TV show Futurama, the aged proprietor of the delivery company Planet Express, Professor Hubert J. Farnsworth, had a habit of entering a room where the other characters were gathered and sharing his trademark line, “Good news, everyone!” Of course, his news was rarely good. More often, it was the beginning of some misadventure through which the other characters would inevitably suffer, often to great comedic effect. So we can forgive you for thinking that we may be standing in his shoes when we tell you that new 409A regulations are good news, but really, hear us (read us?) out.
The IRS released proposed changes to both the existing final regulations and the proposed income inclusion regulations. And the news is mostly good.
The changes are legion, so we are breaking up our coverage into a series of blog posts. This first post is all about the changes related to the end of the service relationship. Check back for future posts discussing other aspects of these proposed regulations.
Severance Safe Harbor Available for Bad Hires. Severance is, surprisingly to some, generally considered deferred compensation subject to 409A. However, severance can be exempt from 409A if the severance is due to a truly involuntary separation under 409A and does not exceed two times the lesser of (1) the employee’s prior annual compensation or (2) the limit on compensation for qualified plans under Code Section 401(a)(17) (currently $265,000, for a limit of $530,000). To qualify for the exemption, the severance must also be paid by the end of the second tax year following the year of separation. This is sometimes referred to as the “two years, two times” rule.
But what if you make a bad hire or otherwise decide you want to fire someone in the same year you hired them? Is the severance safe harbor still available? Treasury confirmed that, indeed, it is. In that case, the limit is two times the lesser of (1) the employee’s annualized compensation for the year of termination or (2) the 401(a)(17) limit.
Reimbursement of Legal Fees for Bona Fide Employment Claims is Exempt. Trial lawyers (or more likely their clients), rejoice! Some employment agreements contain provisions where the employee can be reimbursed for legal fees if they succeed in a claim they bring against the company following termination. These legal fee reimbursement provisions always had an uncertain status under 409A, until now. The IRS has said that if they are a result of a bona fide dispute, they are exempt from 409A.
Employees Becoming Contractors Can Have a Separation from Service. An employee who transitions to an independent contractor status can have a separation from service as an employee in connection with that transition if his/her level of services as an independent contractor are low enough to constitute a separation. Usually, this means that the former employee could provide no more than 20% of the level of services s/he was providing as an employee over the prior 36-months. We always believed this was the rule, but there was some language in the regulations that caused others to question it. The IRS has clarified the rule, stating that such a reduction in services rendered constitutes a separation from service.