Tax Implications of Executive
Reassignments and Terminations

By Lee G. Knight and Ray A. Knight

With the emphasis on downsizing and restructuring, many executives have been forced to transfer or have lost their jobs. These events have resulted in costs to both employer and employee that have tax implications that should be understood by both
parties.

Downsizing and restructuring, frequently caused by mergers and acquisitions, are in vogue and have become common terms in the corporate lexicon. Within this corporate culture, executives frequently become pawns in corporate strategy and may be either reassigned or terminated. In coping with such abrupt career changes, executives often overlook the tax implications of their reassignments and terminations. Yet, positive handling of tax implications may play a significant role in helping executives cope with these transitions.

The tax provisions typically brought into play by reassignments and terminations are as follows:

* Temporary versus indefinite assignments,

* Moving expenses,

* Other employer-provided relocation assistance,

* Relocation and bridge loans,

* Outplacement services,

* Severance pay, and

* Distributions from employee benefit plans.

An awareness of these provisions should benefit not only reassigned or terminated executives, but also executives responsible for minimizing the dysfunctional consequences of downsizings and restructurings.

Temporary Versus
Indefinite Assignment

An executive temporarily reassigned to a job location away from home generally can deduct travel and living expenses incurred during the reassignment. An indefinite reassignment, on the other hand, precludes such deductions.

"Away from home" usually requires an overnight stay and a job location away from the area of the executive's regular place of business. The executive's regular place of business is any location where he or she works on a regular basis, but not necessarily every week or on a set schedule. Regular place of business does not have to be the taxpayer's principal place of business, although in the case of a reassigned executive they probably will be the same. If a reassigned executive has no principal place of employment, "home" is where the permanent residence is located. But unless the executive was regularly employed at this location, he or she generally will
not be able to deduct travel and
living costs incurred during the temporary employment.

A reassignment to a single location for a period exceeding one year is considered indefinite rather than temporary.
However, if the reassignment is realistically expected to last one year or less,
but later is realistically expected to
exceed one year, it is treated as temporary until the expectation changes.

Example: During a corporate restructuring, John Stuart, regularly employed by XYZ, Inc. in Birmingham, is reassigned to Nashville, 210 miles away, for the purpose of completing and closing the sale of an XYZ manufacturing plant in Nashville. XYZ and John reasonably expected John to accomplish this task in nine months. At the end of eight months, however, John and XYZ estimated that he will need an additional seven months (bringing the total to 15 months) to complete the sale because of several unexpected plant defects. Because both time expectations were reasonable, John's employment in the first eight months may be treated as temporary, allowing him to deduct travel and living costs incurred during that time period. Travel and living costs incurred thereafter are not deductible.

A reassignment of less than one year is not automatically deemed temporary; instead, the facts and circumstances of each case determine whether it is temporary or indefinite. An IRS ruling makes the expected duration of the employment away from home a critical fact and circumstance in this determination. If the employment is realistically expected to last (and does last) for one year or less, the employment is treated as temporary in the absence of facts and circumstances indicating otherwise. In contrast, if the employment away from home is realistically expected to exceed one year, it is treated as indefinite regardless of its actual duration.

Example: Following a takeover, Jim Jones, regularly employed by ABC Corporation in Houston, accepted an assignment 250 miles away. Jim realistically expected his work in Dallas to last six months, but it, in fact, lasted ten months. As expected, Jim returned to Houston at the end of his Dallas assignment. Jim's assignment in Dallas is treated as temporary, enabling him to deduct his travel and living costs while there.

Example: Assume the same facts as the above example except that Jim realistically expected his work in Dallas to last 18 months, but it, in fact, was completed in 10 months. Jim's assignment in Dallas is treated as indefinite because he realistically expected the work to last more than one year. Accordingly, Jim's travel and living costs while in Dallas are not deductible.

Temporary employment does not presume it is at the direction of the executive's employer. If an executive seeks discretionary temporary work away from home--for example, while a company is being reorganized or because he or she wants to take advantage of a business opportunity at another location for a period not exceeding one year--he or she still may deduct travel and living costs incurred during this temporary employment. Whether the employer labels the executive's reassignment as temporary or indefinite is not determinative.

The IRS allows a limited deduction for costs incurred during trips home on days off. The costs of meals and lodging at home are not deductible. Round-trip travel expenses (including meals and lodging en route) between the temporary employment location and the executive's home, however, are deductible in an amount not exceeding the costs that would have been incurred if the executive had remained at the temporary employment location. If the executive retains a hotel room at the temporary location during these return trips, no lodging costs en route are deductible.

Moving Expenses

Moving expenses incurred by a reassigned or terminated executive changing jobs for an indefinite period of time are deductible for adjusted gross income if both a distance and time test are satisfied. The distance test requires the executive to commute at least an additional 50 miles from his or her old residence. In other words, if the distance between the new job site and the executive's old residence is at least 50 miles greater than the distance between the old job site and the executive's old residence, the distance requirement is fulfilled.

The time test requires the executive to work for a certain period of time at the new job location following the move. An executive employed full-time in the area of the new job location must work at least 39 weeks during the first 12 months following the move. A self-employed person must work, as a self-employed person or as an employee, in the area of the new job location at least 78 weeks during the first 24 months following the move--of which at least 39 must be in the first 12 months. Both the 39- and 78-week requirements will be waived if the executive dies, becomes disabled, is discharged, or is transferred by a new employer.

Deductible moving expenses fall into two categories, both of which are direct moving costs:

* Costs of moving household goods and personal effects.

* Costs of traveling, excluding meals, from the old residence to the new
residence.

The costs of moving household goods and personal effects include the costs of packing, crating, insuring, in-freight storing, and transporting household goods and personal effects of all members of the executive's household. Tenants, servants, chauffeurs, nurses, valets, and personal attendants are not considered members of the executive's household for this purpose. The costs of insuring and storing the household goods and personal effects during the 30-day period after the items are moved from the former residence and before they are moved to the new residence also are deductible. Likewise, the costs of shipping cars and household pets are deductible.

Deductible travel costs include transportation costs and lodging expenses for members of the executive's household. For travel by car, the executive may deduct actual operating expenses or nine cents per mile, plus tolls and parking. "Members" of executive's household again precludes tenants, servants, nurses, valets, and personal attendants, but includes dogs.

Reasonableness of Moving Expenses. To ensure deductibility, the costs of both categories of moving expenses must be reasonable in amount and bear reasonable proximity in time to the beginning of work at the new location. The expenses will be considered reasonable in amount to the extent they are paid or incurred to make the move from the old residence to the new residence by the shortest and most direct route available via the conventional mode of transportation actually used, and in the shortest period of time required to travel the distance involved by the mode of transportation actually used. The expenses generally will be considered reasonably proximate in time if they are incurred within one year after the executive begins work at the new job location. Moving expenses incurred thereafter are considered reasonably proximate in time only if the executive was prevented from incurring the moving expenses within this one-year period.

Reporting Moving Expenses. Unreimbursed moving expenses are deductible in computing adjusted gross income. Reimbursed moving expenses are neither included in gross income as a fringe benefit nor deducted for adjusted gross income, provided the executive could have deducted the costs if he or she had paid or incurred them directly. The exclusion from gross income does not apply if the executive deducted the moving expenses in a prior year. Congress, however, intended the exclusion to apply unless the employer had actual knowledge of the employee deducting the expenses in a prior year. The employer is under no obligation to determine if the employee actually deducted the expenses in a prior year.

Other Employer-Provided
Relocation Costs

Either the old or new employer of a terminated or reassigned executive may provide relocation assistance in a form other than moving expenses. For example, the employer may reimburse the executive for indirect moving costs, such as costs of house-hunting trips. This reimbursement must be included in the executive's gross income, but it will be a valued benefit to the executive because indirect moving costs are not deductible.

An employer also can assist in the relocation of a terminated or permanently reassigned executive by helping with disposal of a personal residence. This assistance may take various forms, including the following:

* Reimbursing the executive for any loss on sale of a residence and

* Purchasing the executive's residence.

Each of these forms has its own set of tax consequences.

Reimbursement for Loss on Sale. When the employer reimburses the executive for any loss incurred on the sale of a residence, the reimbursement is compensation income to the executive. The taxable event to the executive is the payment; thus, an advance payment for a loss realized on a sale in a subsequent year is taxable in the year of payment.

Example. Bill Richmond's employer, Rapid Achievement, Inc., agrees to reimburse its relocating employees for any economic losses incurred in selling their homes. Based on an appraised value, Rapid Achievement advanced Bill $15,000 to use in buying his new home. Bill's old residence was not sold until the following tax year. Because Bill's basis in the property exceeded the actual net sales price by only $12,500, he returned $2,500 to Rapid Achievement. The full advance of $15,000 is taxable in the year made. Bill, however, may deduct the $2,500 repayment in the year repaid.

Purchase of Executive's Home. Purchasing a reassigned executive's home provides the executive both financial liquidity and peace of mind. The employer assumes responsibility for selling the residence, along with the risk that the ultimate sales price will not equal the price paid the executive.

If the purchase price paid the executive equals the residence's fair market value (usually determined via appraisal), the executive will not have compensation income. Any gain realized on the sale, however, must be included in income.

Example. ABC purchases Paula Sutton's former residence at the average of three independent appraisals of fair market value to assist Paula in transferring to a new work location. Paula must include any gain realized on the sale in income; but she has no additional compensation income.

The IRS has ruled the same tax result is reached when the employer hires an independent company to buy the reassigned executive's former residence.

If the purchase price paid by the employer exceeds the residence's fair market value, the excess is compensation income to the executive. Where a gain is realized on the sale, the executive thus may have both compensation and gain included in income.

Relocation and Bridge Loans

Foregone interest generally is imputed to interest-free or below-market compensation-related loans to employees. The IRS, however, does not require this treatment for employer-provided mortgage and bridge loans secured by or used to buy a new principal residence in connection with the transfer of an employee to a new principal place of work if certain conditions are met:

* The moving expense deduction conditions--distance, time, and reasonableness--are present.

* Tax avoidance is not one of the principal reasons for structuring the transaction as an employee relocation loan.

* The loan is a demand or term loan for which the benefits of the interest arrangements are nontransferable by the employee and are conditioned on the future performance of substantial services.

* The employee certifies to the employer that he or she reasonably expects to be entitled to and will itemize deductions for each year the loan is outstanding.

* The loan agreement requires the proceeds be used only to purchase the new principal residence of the employee.

Bridge loans to employees must meet not only these five conditions, but also the following three to avoid imputation of interest:

* The loan agreement must provide that the loan is payable in full within 15 days after the date of the sale of the employee's immediately former principal residence.

* The aggregate principal amount of all outstanding bridge loans to an employee must be no greater than the employer's reasonable estimate of the amount of the equity of the employee and the employee's spouse in the employee's immediately former principal residence.

* The employee's immediately former principal residence must not be converted to business or investment use.

Example: Jane Fletcher is reassigned by Serenity, Inc. from Los Angeles to Boston. Jane places her Los Angeles home on the market at the prevailing market price, $400,000. The principal amount of the outstanding mortgage loan on the home is $250,000. Serenity can loan Jane up to $150,000 for the purchase of a new home in Boston provided the loan is fully paid within 15 days of the sale of her Los Angeles home and her Los Angeles home remains unrented until its sale.

Outplacement Services

The value of job placement assistance provided by an employer to a terminated or reassigned executive may be excluded from the executive's income as a working condition fringe benefit if the employer gets a substantial business benefit that is distinct from the benefit it would derive from the mere payment of additional compensation. The executive's hypothetical payment for the assistance also must be deductible otherwise as an ordinary and necessary business expense under IRC Sec. 162--i.e., the employee needs to seek new employment in the same trade or business. If, however, an employee can elect to receive cash or other benefits in lieu of the assistance, the assistance cannot be excluded from gross income as a working condition fringe.

The IRS has ruled that the following benefits will establish the substantial business benefit needed to exclude job placement assistance as a working condition fringe benefit:

* Promoting a positive corporate image.

* Maintaining employee morale.

* Avoiding wrongful termination suits.

* Fostering a positive work atmosphere.

* Helping attract quality employees.

Large employers generally will be able to show the applicability of at least one of these benefits, or comparable ones, in their decisions to offer job placement
assistance.

Whether the provision of assistance is part of a temporary phase of an employer's business, such as a reduction in workforce, or a service provided during periods of normal, moderate turnover, has no bearing on whether the assistance is provided for a substantial business benefit. Moreover, the same type of job placement assistance does not have to be offered to all terminated employees. For example, an employee not expected to have difficulty finding comparable employment may not be offered any assistance, while an employee with poor interviewing skills may be provided more focused assistance. Similarly, terminated executives may be provided office space or secretarial assistance in addition to the support provided other employees.

Example: Lead Pencil Company offers job placement assistance to employees terminated as part of a restructuring plan with the intent of promoting a positive corporate image, maintaining employee morale, and avoiding wrongful termination suits. Lead also provides a severance-pay plan under which qualifying employees generally are paid five percent of their annual salaries when they are terminated. Employees who accept job placement assistance, however, are paid only four percent of their salaries as severance pay. Betty White, who had a salary of $300,000, is terminated and accepts job placement assistance. Lead pays Betty $12,000 (four percent of $300,000), plus the job placement assistance. Since Betty would have been paid $15,000 (five percent of $300,000) without the assistance, she has constructively received $3,000 ($15,000­$12,000) and is taxed on the full $15,000. Without the election to receive the $3,000 additional severance pay instead of the job placement assistance, Betty would have included only $12,000.

The value of any job placement assistance that does not qualify as an excludable working condition fringe benefit may be deducted as an ordinary and necessary business expense under IRC Sec. 162. As a miscellaneous itemized deduction, however, it is subject to the two percent of adjusted gross income floor.

Severance Pay

Severance pay provided by an employer to a terminated executive is includable in gross income as compensation. Neither the IRC nor the regulations defines the term "severance pay," but the courts have interpreted it to include payments to employees because of terminations resulting from either their own situations or their employers' situations. Thus, taxable severance pay has included payments to employees retiring due to ill health, payments given in lieu of a probationary period for improving performance, payments equal to pension benefits that would have been paid if an employee had not resigned, and reimbursements for personal expenses incurred in finding new positions after being terminated. The courts also have interpreted severance pay to include payments to employees in connection with the change or termination of the employer's business, such as where the employer sells a subsidiary or various properties, merges with another corporation or institution, or closes an office in the employee's city of residence.

Golden Parachute Payments, the lucrative severance payments often paid executives whose companies have been taken over, are treated as payments in the nature of compensation if they arise out of an employment relationship or are associated with the performance of services. An excess parachute payment, however, is nondeductible by the employer and subjects the recipient to a nondeductible 20% excise tax. A parachute payment is a payment in the nature of compensation to or for the benefit of a disqualified individual if--

* it is contingent upon a change in ownership or effective control of the corporation or a change in the ownership of a substantial portion of the assets of the corporation, and

* the present value of the contingent payment equals or exceeds 300% of the individual's base amount (i.e., the individual's average annual taxable compensation from the corporation during the five-year period preceding the change in ownership or control).

The term "disqualified individual" includes any employee or independent contractor who performs personal
services for the corporation and
who is an officer, shareholder, or
highly compensated individual of the corporation.

The excess portion of a parachute payment is the amount paid in excess of the disqualified individual's base amount, defined as the average annual includable compensation paid by the corporation during the most recent five taxable years. For an individual employed less than five years, the base amount is the average
compensation for the entire period of employment.

Example: Bill Bass was an executive officer of ABC Company when it was taken over by XYZ Company. Under an agreement, ABC paid Bill $1,000,000 on the date of the takeover. Bill's base amount was $250,000. The $1,000,000 payment to Bill was a parachute payment because it was contingent on a change in control of the corporation and it exceeded $750,000, 300% of his
base amount. ABC cannot deduct and
Bill must pay the excise tax on the excess parachute payment, $750,000 ($1,000,000 payment less $250,000 base amount).

Distributions from Qualified Plans

An executive who receives a distribution from a retirement plan upon termination generally will be taxed on the distribution to the extent it is not attributable to the executive's cost basis. Certain lump-sum distributions to employees, however, qualify for special elective treatment that can reduce the tax bite. A distribution of 50% or more of the executive's plan balance generally can be rolled over into an IRA, qualified trust, or employee annuity plan because the executive is separating from service with the employer. If the rollover is completed within 60 days of
receiving the distribution, the executive will not be taxed on the distribution until it is distributed by the IRA or
other retirement plan receiving
the rollover. The rollover, however,
may cause the executive to lose the
right to averaging and long-term
capital gain treatment on the ultimate distribution.

Cash or deferred arrangements (CODAs), also known as IRC Sec. 401(k) plans, permit employees to withdraw amounts for hardship before age 59 wQ without being subject to the 10% penalty for early withdrawals under IRC Sec. 72. The withdrawals, however, are subject to state and Federal income taxes.

Hardship withdrawals are permitted only if the participant has an immediate and heavy financial need and the withdrawal is necessary to meet the need. The determination of whether an employee has an immediate and heavy financial need is made on the basis of all relevant facts and circumstances. The regulations clarify "immediate and heavy financial need" by providing the following examples of qualified needs:

* Medical expenses.

* Purchase (excluding mortgage payments) of a principal residence for the employee.

* Payment of tuition and related educational fees for the next twelve months of post-secondary education for the employee, spouse, or children.

* Payments of amounts necessary to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage of the employee's principal residence. *

Lee G. Knight, PhD, is the E.H. Sherman Professor of Accountancy at Troy State University. Ray A. Knight, JD, CPA, is senior manager with the Atlanta office of KPMG Peat Marwick LLP.