Severance Pay Under Section 415
Rev. 04/25/08, E-mail Alert 2008-6

We have recently provided sponsors of our prototype defined contribution plans with Code §415 amendments, to reflect Final Regulations that were released last April.

One of the major changes in the Regulations related to the necessity to include certain post severance compensation in the definition of Code §415 Compensation. Apparently, some plan documents (not McKay Hochman’s) had previously been drafted to state that any amounts paid after separation of service (termination of employment), even regular pay, would be disregarded for all plan purposes. While this language was not wrong, the IRS/Treasury became concerned that some amounts of compensation that were actually earned during the participant’s period of employment would be disregarded. Thus, the Final Regulation was drafted to state that certain amounts which accrued during the participant’s employment, but which are paid afterwards, are now included in §415 Compensation. Specifically, the Regulation provides the following:

(ii) Regular pay after severance from employment. An amount is described in this paragraph (e)(3)(ii) if—
(A) The payment is regular compensation for services during the employee’s regular working hours, or compensation for services outside the employee’s regular working hours (such as overtime or shift differential), commissions, bonuses, or other similar payments; and
(B) The payment would have been paid to the employee prior to a severance from employment if the employee had continued in employment with the employer.

An additional requirement is that of the timing of when the amount is actually paid. The Regulation provides the following in this regard:

…provided the compensation is paid by the later of 2 1⁄2 months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan.

The meaning of the above is that amounts that have accrued, but not been paid to the participant at the time of separation, must be included in the plan’s Code §415 Compensation. The example we have previously used is that an employee terminates on November 30. Their paycheck at that time only reflects payments for services through November 15. On December 15, the now ex-employee receives their final check for the amounts they earned through November 30. This amount must be considered for Code §415 Compensation purposes. Similarly, commissions or bonuses earned while working and paid during the period ending the later of 2½ months or the end of the limitation year after severance are other examples of pay earned before severance and paid after severance, that must be considered.

Subsection (e)(3)(iii) of the regulations address optional amounts that are paid post severance that an employer may nonetheless choose to include in Code §415 Compensation. Examples of these are accrued vacation, sick and other leave that could have been taken had the employee continued in employment, pay differentials for employees who enter qualified military service and distributions from unfunded nonqualified deferred compensation plans that would have been paid during the time frame referenced above, even if the employee had not separated from service.

The Regulations go on to clarify the IRS /Treasury position on other post severance payments:

Other post-severance payments…Any payment that is not described in paragraph (e)(3)(ii) or (iii) of this section is not considered compensation under Code §415 if paid after severance from employment with the employer maintaining the plan, even if it is paid within the time period described in paragraph (e)(3)(i) of this section. Thus, compensation does not include severance pay. (Emphasis added)

It has become apparent during recent client calls that there is confusion in the marketplace as to what amounts must be counted as 415 compensation after termination of employment and what amounts may not be considered. It is clear that the IRS does not want pure severance counted.

Theoretically, pure severance pay is not payment for services rendered and should not be considered plan compensation. Often times it is a payment for the release of legal liability for terminating an employee’s services. Other times the payment is unrelated to any actual services, but is a stated amount such as $1,000. Though not our position at McKay Hochman, some industry practitioners argue that the amount can be counted if actually paid prior to or commensurate with the separation.

In a prior posting on our web page since deleted, McKay Hochman dealt with the issue of “wage continuation” arrangements and whether or not such amounts could or should be counted. During a recent workshop on 401(k) plan issues at the Great Lakes Benefit Conference in Chicago, in early April, the issue was raised with a member of the Office of Treasury Counsel. Counsel’s Office has an integral role in the drafting and release of any Treasury Regulation. As with any public speech given by Government employees, the representative made the normal disclaimer that the opinion being given was his own and does not necessarily represent the Department’s position. That being said, he stated his belief that any wage continuation arrangement where the employee continued to be remunerated for a set period after termination was, in fact, severance and should not count. Not even for the first 2½ months. Clearly, this is the safest and most conservative position to take. It is especially true, if the period is arbitrarily chosen and is unrelated to the employee’s prior period of service. However, some practitioners have taken the position that if the wage continuation period is tied to the employee’s period of service, such as one month for each year of employment, then it could be counted. Some senior staff at McKay Hochman accepted this position. However, as already stated, the safest position for the client is the best approach, and that means not counting any wage continuation payments.

The next issue to be addressed is that the rules addressed above apply to Code §415 limitations. As illustrated by the flexibility of the McKay Hochman Prototypes, employers are not bound to using only one definition of Compensation in a plan. As a result, a plan could theoretically restrict employee deferrals or employer allocations to a different definition of compensation that does not include any post termination amounts. Discrimination testing under a plan is tied to Code §414(s) compensation rather than 415.

The Regulations also coordinated the Code §415 limit with the Compensation limit under Code §401(a)(17). This has raised questions about the ability of those earning above the Code §401(a)(17) limit to defer on those amounts. For an HCE earning $300,000 can they defer 5% of all of their pay or must they stop after deferring against $230,000. The regulations make clear that they do not have to defer against the first $230,000. Does that mean they can defer against all $300,000 so long as they don’t violate the $15,500 Code §402(g) limit? Based on statements made at earlier ASPPA conferences, it appears that this is okay. When testing, only amounts up to the Code §401(a)(17) limit will be considered. Thus, the employee’s deferral rate will be 6.52% rather than 5%.

The 401(k) Regulations were modified to reflect that amounts paid post-severance can not be deferred against unless they fall within the Code §415 definition.