Tax Status of Distributions Resulting From Separation From Service

The recipient of a lump sum distribution from a qualified plan is generally entitled to favorable tax treatment. Examples of such favorable tax treatment include five- or 10-year averaging, roll-over into another qualified plan or roll-over into an IRA. The excise tax is multiplied by five if the distribution qualifies as a lump sum distribution and lump sum treatment is elected. Thus, the taxpayer is entitled to a separate threshold amount for the lump sum distribution.

Definition of Lump Sum Distribution

In general, a lump sum distribution is a distribution from a qualified plan of the employee's entire balance in the plan and this distribution is made within one taxable year of the recipient. The distribution must be on account of death, attainment of age 59 1/2 or "separation from service."

Separation From Service

One of the criteria for determining lump sum status is that the employee separate from service. Although the phrase "separation from service" is very significant, it is not defined in the code or regulations. The courts, using Congressional Committee Reports for guidance, have interpreted separation from service to mean the employee's severing his or her connection with the employer. The Tax Court has held that distributions which are incident to corporate mergers, reorganizations or liquidations, with the employee continuing to work for the surviving entity, can be considered as meeting the requirement of separation from service only if the transaction results in a substantial change in the makeup of employees. Gittens v. Commissioner, 49 T.C. 419 (1968).

The IRS has ruled that an employee who ceases employment status (as a common law employee) and becomes a partner in the employer entity is not considered to have separated from service. (Rev. Rul. 81-26, 1981-1 C.B. 200.) The Claims Court has reached the same conclusion in Ridenour v. United States, 3 Cl. Ct 128 (1983) that the relevant factor is the continuation of providing services and not the status of the person providing the service. Thus, an individual who continues to provide services, even though his status has changed, has not separated from service within the meaning of Sec. 402(e)(4)(A).

The IRS has ruled in Rev. Rul. 69-647 (1969-2 C.B. 101) that a senior executive who retired from full-time employment and continued to render services on a part-time basis as a consultant was considered to have separated from service. Factors which the IRS considered in reaching this conclusion are:

1. The employer did not exercise supervision over the former employee;

2. The employer did not require compliance with detailed orders or instructions;

3. There was not an established schedule for performing the services and it was not necessary for the taxpayer to obtain the employer's permission to be absent from work;

4. The taxpayer rendered only advisory services on an irregular basis.

What the IRS is conveying in this ruling is that the former employee must become an independent contractor and as such the services rendered must be on an irregular basis. The issue of separation from service has been dealt with by the Tax Court under various fact patterns.

In Bolden v. Commissioner, 39 T.C. 820 (1963), an individual sold the stock in his closely held corporation. The selling shareholder, for a payment of $4,800, entered into an agreement with the company to stay in its employ for a four-year period in an advisory and consulting capacity and to spend more than 20 hours per week and more than five months per year rendering services. After the sale, the seller accepted employment with another company. The only service he rendered for his former employer was to answer some questions. The Tax Court determined that the employment agreement was sufficient to establish that the individual was employed by the company even though services were not rendered. Accordingly, there was not a separation from service and the employee did not qualify for beneficial treatment for distributions which he received from the plan.

In Reinhardt v. Commissioner, (85 T.C. 511 1985), an employee- shareholder sold his equity interest in the corporation and changed his position from that of employee to independent contractor. However, he continued to perform the same services with the same degree of regularity. The Tax Court stated that it was clear that even though the taxpayer may have become an independent contractor, he did not separate from service and was therefore not entitled to the aforementioned beneficial tax treatment.

A recent private letter ruling (PLR 8837011) further presents the IRS position on the issue of separation from service. In addition, the ruling discusses whether or not a distribution received 10 years after separation from service is considered to be "on account of separation from service." The fact pattern in the ruling is as follows:

Individual N, an officer and shareholder of Company A, sold his stock and terminated his employment in November 1979, at which time he ceased to participate in the qualified plan sponsored by Company A. Individual N entered into a 10-year consulting and non-compete agreement with Company A for which he was to receive a monthly salary. In return for this salary, individual N was obligated to perform certain training and supervisory functions on an "as needed" basis. Individual N in performing these services was not subject to the control or supervision of Company A. Although individual N was required to render services through 1988, he was not called upon to do so since 1980.

With respect to the issue of separation from service, the IRS reiterated prior case law stating that "separation from service" does not occur unless the employee severs his connection with the employer. A change in the employment relationship, such as that from common law employee to independent contractor, satisfies this requirement. In issuing a favorable ruling, the IRS considered the following factors: 1) The contract did not provide any formal schedule or duty assignments; 2) Individual N was not required to obtain permission to be absent from work; and 3) Individual N was not subject to the control or supervision of Company A.

Another factor presented by the IRS was that individual N did not in fact render services since 1980. However, it appears that this factor was not crucial in determining whether or not there was a separation from service.

Year in Which Distribution Must Be Made

In PLR 8837011, discussed above, individual N separated from service in 1979 but did not receive his distribution until 1988. In determining whether the distribution was "on account of" separation from service, the IRS stated that it does not believe that the distribution must be made in the year of or in the year following separation from service. The term "on account of" includes distributions to which an employee is entitled because of earlier separation from service. Thus, a distribution of Individual N's entire account balance 10 years after separating from service satisfies the requirement of being "on account of" separation from service.

Additional Tax on Early Distributions

Taxable plan distributions received prior to attending age 59 1/2 are subject to a 10% additional tax. A distribution which is rolled over and thus not subject to ordinary income tax is not subject to the 10% additional tax.

Distributions made under the following circumstances are exempt from the additional tax: 1) distribution is made to a beneficiary after the death of the employee; 2) distribution is attributable to the employee's being disabled; 3) distributions are payable in equal periodic payments over the life expectancy of the employee or joint lives of the employee and his beneficiary; 4) distribution is made after separation from service on account of early retirement after attainment of age 55.

Thus, not only is the issue of separation from service relevant in determining whether a distribution qualifies for averaging treatment or for rollover, it is also important in determining whether or not a distribution made to an individual between age 55 and 59 1/2 is subject to the additional 10% tax. In PLR 8837011, Individual N had not attained age 55. The distribution was not subject to the 10% additional tax as it qualified as a lump sum distribution and was timely rolled over into an IRA. However, had individual N been over age 55 when considered to have separated from service, a taxable distribution would not have been subject to the additional tax, had the distribution not been rolled over to an IRA.

It should be noted that it is possible for a distribution to qualify as a lump sum distribution eligible for favorable averaging treatment and still be subject to the 10% additional tax. This would occur if the distribution is to an individual under age 55 who has separated from service, which is the case of individual N in PLR 8837011. However, the 15% excise tax may be reduced when an individual pays the additional 10% (premature distribution) tax for distributions received before age 59 1/2 to the extent that the 10% tax is applied to such distributions.