Pursuant to the final regulations under Section 409A of the Internal Revenue Code of 1986, as amended, a termination of employment generally occurs at such time as the employer and employee reasonably anticipate that the level of services to be performed after such time, whether as an employee or an independent contractor, would permanently decrease to no more than 20% of the average level of services performed over the immediately preceding 36-month period (or, if services were performed for less than 36 months, over the full period of services). Further, an independent contractor has a separation from service when there is a good faith and complete termination of the underlying contractual relationship.

The proposed regulations under Section 409A (available here) recently issued by the IRS would amend the final regulations to clarify that a service provider who ceases providing services as an employee, but becomes (or continues as) an independent contractor for the same service recipient at a level of services that does not constitute a termination of employment as an employee (e.g., less than 20%), will not have a separation from service with the service recipient unless and until the service provider has a separation from service as an independent contractor. This would occur even if the level of services reasonably anticipated to be performed in the future were to decrease to less than 20% of the average level of services performed over the immediately preceding 36-month period.

As a result, depending on the level of services performed during the relevant periods, an individual who goes from a full-time employment position to a post-employment independent contractor role may not incur a separation of service for purposes of payment of severance subject to Section 409A unless and until the performance of services has terminated completely.

For example, a chief executive officer who steps down as CEO but continues to serve in an independent contractor role as the corporation’s non-executive chairman of the board of directors at a time commitment anticipated to exceed the 20% service level threshold at the time of the transition would not be entitled to payment of deferred compensation triggered upon a termination of employment as CEO until he or she ceased to be a member of the board or otherwise perform services in any other capacity, even if the time commitment subsequently dropped below the 20% threshold as of any future date.

By contrast, if a chief executive officer were to have continued in an employment capacity (i.e., as the Executive Chairman), it is possible that there could have been a separation from service when the level of services dropped by a sufficient amount, even if not reduced to zero. For example, assume an individual worked 2,000 hours per year as CEO from 2000 to 2012, then 1,000 hours per year as Executive Chairman from 2013 to 2015, then only 150 hours per year as a non-employee director in 2016. The individual’s separation from service would have occurred when the Executive Chairman role ended (and not when the CEO role ended). If that same individual did not continue in an employee capacity as Executive Chairman, but instead transitioned to an independent contractor role at that time working 1,000 hours per year, then separation from service would not occur until the individual no longer performed any services – whether as a director or otherwise – for the corporation.