What is a Section 409A Separation from Service?

Internal Revenue Code Section 409A governs nonqualified deferred compensation (NQDC) plans, which allow payment for work to be postponed to a future year. A primary trigger for paying out these funds is a “separation from service,” a term with a precise definition under Section 409A that differs from a standard termination of employment. Failing to follow the strict timing and definitional rules can lead to adverse tax consequences for the employee, including immediate taxation of all deferred amounts, a 20% additional tax, and penalty interest.

Defining a Separation from Service

A separation from service under Section 409A occurs when an employee dies, retires, or otherwise has a termination of employment. However, the analysis does not stop at the formal termination date. Treasury Regulations require a “facts and circumstances” assessment to determine if a separation has truly taken place, centering on whether the employer and employee anticipate a permanent reduction in services.

To provide objective measures, the IRS established default presumptions based on the level of service compared to the average over the preceding 36-month period. A separation from service is presumed to have occurred if the employee’s rate of performing services drops to 20% or less of this historical average. Conversely, a separation is presumed not to have occurred if the continuing service level is 50% or more, while situations between these thresholds are judged on specific facts and circumstances.

The rules also address leaves of absence. A bona fide leave of absence, whether paid or unpaid, is not considered a separation from service if the period does not exceed six months, or for as long as the individual retains a statutory or contractual right to reemployment. If the leave extends beyond six months and there is no reemployment right, a separation is deemed to occur on the day after the six-month period ends. This period can be extended up to 29 months for a leave due to a medically determinable disability.

Rules for Continued Service After Termination

The analysis becomes more complex when an individual continues to provide services in a different capacity after their formal employment ends, such as transitioning to an independent contractor. For Section 409A purposes, the form of the relationship is less important than the substance of the services provided. All compensated services, whether as an employee or a contractor, are aggregated to determine if a separation has occurred.

These continuing service arrangements are evaluated using the same service level thresholds established by the IRS. This prevents individuals from technically terminating employment to access deferred compensation while continuing to provide a significant level of service.

A distinct set of rules applies when an individual continues service as a director. Service as a director is not aggregated with service as an employee, so an employee who retires and then joins the board would be considered to have separated from service as an employee.

This default position can be altered by the deferred compensation plan. A plan can specify that service as a director will be counted, which would delay the separation event until the individual ceases to provide services in all capacities.

The Six-Month Payment Delay for Specified Employees

A special payment timing rule applies to certain individuals at publicly traded companies known as “specified employees.” Section 409A mandates that any NQDC payment triggered by a separation from service for these individuals must be delayed for six months. This provision prevents top executives from immediately accessing deferred funds if a company’s financial health is uncertain.

A specified employee is a “key employee” of a publicly traded company. A key employee is an officer with annual compensation over $230,000, a 5% owner of the business, or a 1% owner with annual compensation over $150,000. Companies must formally identify this group of employees annually.

The identification process involves setting a “specified employee identification date,” often December 31. Individuals meeting the key employee criteria during the 12-month period ending on this date become specified employees for an effective period that usually begins the following April 1. An employee must be on this list at the time of their separation to be subject to the payment delay.

If a specified employee separates from service, any resulting NQDC payments cannot be made for six months and one day. Payments that would have been made during this window are accumulated and paid in a lump sum after the delay period ends. If the specified employee dies during the waiting period, the payments can be made immediately to their beneficiary.

Separation from Service in Corporate Transactions

The rules for determining a separation from service apply differently in corporate transactions like mergers and acquisitions. The outcome depends on whether the deal is an asset sale or a stock sale. This distinction dictates whether employees are considered to have terminated employment with the seller, affecting their deferred compensation.

In a stock sale, the ownership of the company changes, but the employing legal entity does not. Employees of a sold subsidiary continue to be employed by that same entity under a new parent company. Therefore, a stock sale does not, by itself, create a separation from service.

In an asset sale, the buyer acquires the seller’s assets, not the corporate entity. The seller’s employees who are hired by the buyer are legally considered to have terminated employment with the seller and started new employment with the buyer. This termination constitutes a separation from service, which can trigger NQDC payments.

Regulations allow the buyer and seller in an asset sale to make a joint election. They can agree in writing before closing to specify whether the transaction will constitute a separation from service for transferring employees. This election must be applied consistently to all affected employees as part of an arm’s-length transaction.