Post-severance Compensation
Rev. 01/12/06, E-mail Alert 2006-1

Updated in 2008

Even though the IRS issued guidance on this topic last year, it is still one of the most frequently misunderstood issues.

Until recently, there was no IRS guidance on post-severance compensation. When an employee received a severance package, arguably, the employer had wide latitude in allowing post-severance compensation to be included for qualified plan purposes. It was not uncommon for post-severance compensation to count towards deferrals, matches, and other employer contributions for periods of up to six months or sometimes even longer.

The matter has been resolved by the IRS. And, although we addressed it at length in a prior issue of this newsletter, many questions have been raised about the extended use of post-severance compensation for qualified plan purposes.

Basically, post-severance compensation may be included in compensation if it’s paid within 2½ months after separation from service. This is only for payments — regular compensation, overtime pay, commissions, and bonuses — that would have been paid had the participant continued in employment. Leave-related severance payments for bona fide sick, vacation, and other leave may be included in compensation only if the leave had been accrued before leaving and could have been used had employment continued. This is effective for plan years beginning on or after January 1, 2005.

Example: An employee terminated on June 10, 2005, with three weeks of unused vacation time. The participant may make elective deferrals on the compensation amount and is entitled to have that payment included in plan compensation for employer contribution purposes, provided it is paid within 2½ months of severance. The 2½-month limit is absolute. If the employee is given six months of pay on a payroll basis, only the first 2½ months of post-severance payroll would be eligible for deferrals and employer contributions.

Employer discretion is no longer permitted. Employees may not defer on post-severance compensation in excess of 2½ months.

IRS Employee Plans News Special Edition of June 2, 2005 addressed the Proposed Section 415 Regulations that included the post-severance compensation rules which were effective for plan years beginning on or after January 1, 2005.