In April, the IRS issued final regulations under Section 415 of the Internal Revenue Code (the “Code”). These regulations finalize rules proposed in May of 2005 and represent the first comprehensive overhaul of the Section 415 rules since 1981. For sponsors of defined contribution plans, one of the most newsworthy of the many changes is a revamping of the rules governing deferrals from compensation an employee receives after terminating employment.
These rules are essential to computing post-severance deferrals under 401(k), 403(b), and 457(b) plans, because parallel changes to regulations under those sections permit such deferrals only from “compensation” that meets the definition in Code Section 415(c)(3). Thus, unless the compensation at issue falls within the new regulatory definition of Section 415(c)(3) compensation, the departing employee cannot defer any part of it to the employer’s 401(k), 403(b), or 457(b) plan.
As a general rule, post-severance pay is not treated as Section 415(c)(3) compensation. The new regulations carve out several exceptions, however, for the following kinds of pay.
MANDATORY INCLUSION: TIMING RULES
First, the new regulations require the inclusion of “regular” pay (including overtime pay, shift differential pay, commissions, and bonuses) that (1) would have been paid had the participant remained employed, and (2) is paid before the later of 2 1⁄2 months after the employee’s termination of employment or the end of the Section 415 limitation year (typically, the plan year) which includes that date.
The period specified in the proposed regulations did not include any reference to the limitation year, so the final regulations will in many instances permit a considerable extension of the period during which an employee can defer out of post-severance compensation. (For purposes of computing the relevant period, 457(b) plans may substitute the calendar year for the limitation year.)
PERMISSIBLE INCLUSION: TIMING RULES AND PLAN DOCUMENT REQUIREMENT
The final regulations also permit the inclusion of the following types of compensation, provided that (1) the compensation is paid within the same period, and (2) the plan in question provides for its inclusion:
- the cashout of accrued sick, vacation, or other leave, so long as the employee would have been able to use the leave if employment had continued; and
- certain taxable payments of nonqualified deferred compensation, so long as the payments would have been made at the same time if employment had continued (i.e., so long as the payment is not triggered by termination of employment).
Finally, certain payments to disabled employees and individuals in qualified military service may also be included in the new definition of Section 415(c)(3) compensation. Such payments are includible only if the plan so provides; they are not, however, subject to the timing requirements applicable to the other exceptions to the general rule.
The new regulations also expressly exclude certain types of pay from the scope of Section 415(c)(3) compensation. Severance pay, “parachute payments,” and distributions from nonqualified deferred compensation plans (unless the payment would have been made at the same time, regardless of the employee’s severance from employment) are among the specifically excluded varieties.
Plan sponsors should review their plan documents and their payroll procedures to determine whether they conform with the mandatory provisions of the new regulations. They should also take this opportunity to ensure that optional plan provisions properly reflect their intentions with respect to employee deferrals from post-severance compensation.