Leaving a Fund: Deferred Pay, Make-Whole and Garden Leave Taxes

What happens to each piece of pay when you leave?

The plan or agreement behind each piece decides what you keep. The tax follows from that: pay you never receive is never income, and pay you do receive is almost always ordinary income in the year it reaches you.

A departure is simple when you forfeit what is unvested and move to a plain salary. It needs professional judgment when a plan accelerates or keeps vesting, the new firm's make-whole has its own vesting or clawback, a co-invest stake is bought back below value, you move states, or you start your own fund. Before your last day, copy each plan, your vesting statements, your separation agreement and the new firm's offer letter; the full list is below. Reading each plan against both W-2s and every K-1 for the year is part of tax work for fund employees.

What happens to my unvested deferred bonus or deferred compensation if I quit, am fired, or am let go?

The plan decides. Many plans forfeit unvested tranches (the portions of a deferred bonus that vest one at a time) when you resign or are fired for cause. Some keep them vesting on schedule, or vest them at once, when you are let go without cause or retire under the plan's terms.

• Forfeited. A tranche you lose was never income. It also never had Social Security and Medicare taken, because deferred pay counts for those taxes only once it is no longer at risk of forfeiture (26 USC 3121(v)(2)(A)). There is nothing to report and nothing to claim back.
• Vests at once (acceleration). If being let go without cause makes a tranche vest, Social Security and Medicare apply to its value on that date. Income tax comes when the plan pays it, at once or on the original schedule.
• Keeps vesting. If tranches stay alive after you leave, each follows its original schedule. If the only condition left is that you not work for a competitor, the IRS usually treats the tranche as already vested (Reg. 1.83-3(c)(2); Reg. 31.3121(v)(2)-1(e)(3)). So Social Security and Medicare may be due at your exit date, not at the later vesting date. Check how your plan and payroll treated it.

Do I get back Social Security and Medicare already taken at vesting?

Usually not. Once a tranche is counted for Social Security and Medicare, neither it nor its later earnings are counted again (26 USC 3121(v)(2)(B)). The regulation lets the employer claim a refund when it overestimated the amount at the time it counted it (Reg. 31.3121(v)(2)-1(f)(2)(iii)). It has no rule refunding tax on a vested tranche that later loses value or is never paid, so a refund then is unlikely. How deferred pay is taxed while you stay is covered in Deferred bonus at a fund manager.

Can I take my vested deferred pay early after I leave?

Usually not. A section 409A plan may not speed up any payment, and a later change cannot take effect for 12 months and must push each payment back at least 5 years (Reg. 1.409A-3(j)(1); Reg. 1.409A-2(b)(1)). Leaving can itself be a payment date if the plan says so (Reg. 1.409A-3(a)). The details are in Deferred bonus at a fund manager.

I forfeit unvested carry: is there anything to deduct?

Possibly, if you paid for the points. With a section 83(b) election, the loss is what you paid, less anything you got back, and is a capital loss if the interest was a capital asset (Reg. 1.83-2(a)). Without an election, the regulation treats the same difference as an ordinary gain or loss (Reg. 1.83-1(b)(2)). If the firm treated you as a partner from the grant with no election (Rev. Proc. 2001-43), no rule says how income you were taxed on but never received is recovered on forfeiture; have your final K-1 reviewed. See Carry points for fund employees. Whether carry you keep after leaving is still long-term is covered in Carried interest and the three-year rule.

The firm buys back my co-invest stake: how is it taxed?

Usually as a capital sale. A co-invest or employee-fund stake is normally an interest in a partnership. Selling it gives capital gain or loss, except for the part tied to income the partnership has earned but not yet collected and to property it holds for sale (its unrealized receivables and inventory items), which is ordinary income (Publication 541, "Disposition of Partner's Interest").

If the fund itself redeems your whole interest, you have gain only to the extent the money you receive is more than your adjusted basis. If you are paid partly in securities instead of cash, the gain test has special rules (26 USC 731(c)); have it reviewed. You have a loss only if the payout is entirely money, unrealized receivables and inventory items, and your basis is higher (Publication 541). If the fund holds back part of the payout until its audit, your interest is not fully liquidated until the last payment: gain counts once the cash you have received is more than your basis, and a loss waits for the final payment (Reg. 1.731-1(a); Reg. 1.761-1(d)). Expect a final K-1 covering your share of income up to the exit.

A "bad leaver" buyback at cost or below value needs a closer look. If the stake came to you in connection with your work and was still unvested, the answer turns on a section 83(b) election. With one, a sale that is in substance a forfeiture is treated as one, so the loss is limited to what you paid, less what you got back (Reg. 1.83-2(a)). Without one, the buyback is generally treated as a forfeiture, and the difference between what you paid and what you get back is an ordinary gain or loss (Reg. 1.83-1(b)(2)). If you bought a vested stake with your own money and are paid less than your basis, you may have a capital loss; the redemption rules above decide when you can claim it.

How is a make-whole (buyout) from my new firm taxed?

A cash make-whole or sign-on bonus is wages from the new firm in the year it is paid, with income tax withholding and Social Security and Medicare. The IRS ruled that a bonus paid to establish employment is wages, even when the contract says it does not depend on future work (Rev. Rul. 2004-109). It is not capital gain, even if it replaces deferred pay that tracked a fund.

A make-whole paid as new deferred awards follows the new plan's own rules: usually Social Security and Medicare when each award vests, and income tax when it is paid. A make-whole paid as restricted shares or a fund interest that vests over time is generally income at its value when it vests, unless you made a section 83(b) election within 30 days of receiving it (26 USC 83(a) and (b)(2)).

A clawback does not delay the tax. If the offer letter says you must repay the make-whole if you leave within a set period, you still report the full amount in the year paid. A later repayment is handled in Repaying a bonus you were taxed on.

Is garden-leave pay taxable as wages?

Yes. During garden leave (paid notice) you are still an employee, just told not to work. The pay is ordinary wages on your W-2 from the old firm, with income tax withholding and Social Security and Medicare (Publication 15; Publication 525). It also counts toward that firm's Social Security wage base for the year.

If deferred pay is due on your "separation from service", the plan's date may not be your last payroll day. Under section 409A it turns on whether you still perform services, not only on whether you are still paid (Reg. 1.409A-1(h)(1)(ii)). Ask the plan which date it uses; it can move a payment into another year.

Is a non-compete payment wages or capital gain?

It is ordinary income, not capital gain, and is usually reported as wages. Three IRS positions point that way:

• The IRS treats refraining from services under a covenant not to compete as performing services, for the fringe-benefit rules (Publication 525).
• A payment to an employee for cancelling an employment contract is ordinary income and wages for Social Security, Medicare, unemployment tax and income tax withholding (Rev. Rul. 2004-110).
• A payment escapes wages only if the employee gives clear, separate and adequate value that does not depend on the employment relationship (Rev. Rul. 2004-109).

No IRS ruling squarely addresses whether a non-compete payment to a former employee is wages for Social Security and Medicare. If you receive one on a Form 1099 rather than a W-2, or over more than one year, have it reviewed before you file.

How is severance taxed, and in which year?

Severance is income and wages for Social Security, Medicare, income tax withholding and federal unemployment tax (Publication 15; Publication 525). It is taxed in the year you receive it. Installments are taxed as each one is paid, so severance spread into the next year lands partly on next year's return.

Payroll treats severance as supplemental wages. It may withhold a flat 22% if it withheld income tax from your regular wages this year or last year. It must withhold 37% on supplemental wages above $1,000,000 it pays you in the year, counting businesses under common control (Publication 15). These are withholding rates, not your tax rate.

A severance schedule is often deferred pay under section 409A, and then it usually cannot be sped up once agreed. Two exceptions can keep it outside: it is all paid by the 15th day of the third month after the year you become entitled to it, or it is paid only because you were let go, is no more than two times the lesser of your prior year's pay or the retirement-plan pay limit, and is paid by the end of the second year after the year you leave (Reg. 1.409A-1(b)(4) and (b)(9)(iii)). Whether one applies depends on the agreement's terms.

Two employers in one year: how do I get back excess Social Security?

You claim it as a credit on Schedule 3 of your Form 1040. Each employer withholds Social Security of 6.2% on wages up to $184,500 and cannot count what your other employer paid, so two employers together can take more than the maximum for the year (Topic 608; Publication 505).

• Too much from one employer. That employer should fix it. If it does not, claim a refund on Form 843 with your W-2s attached (Topic 608).
• Married filing jointly. You and your spouse each figure any excess separately.
• 401(k) deferrals. The yearly limit of $24,500 is for you, not for each employer, and you must watch the total. If the two plans together took more, tell a plan by its deadline so it pays the excess back to you by April 15 of the next year; an excess left in the plan is taxed twice (Publication 525).
• Medicare. Regular Medicare has no wage cap, so there is no excess to recover. Additional Medicare Tax withheld is settled on Form 8959 with your return (Topic 560).

Who covers the withholding gap?

You do. Each employer withholds the 0.9% Additional Medicare Tax only on wages it pays you above its own threshold, so two employers can each withhold too little (Topic 560), and a flat 22% on a final bonus or a sign-on can fall short of your actual rate (Publication 15). How to close both gaps is in Estimated tax in a big bonus year.

I'm leaving to launch my own fund: what else changes?

Your pay stops being W-2 wages with withholding. Income from your management company and general partner usually arrives on K-1s with nothing withheld, so estimated payments usually start in the first year (Publication 505). Whether that income carries self-employment tax is covered in Limited partner self-employment tax for fund managers. What the fund, the general partner and the management company each file is in First tax year for a new hedge fund.

What should I collect before my last day?

Copies are much harder to get once your system access ends. Gather:

1. Every deferred compensation plan document, award letter and deferral election.
2. Vesting and account statements for each tranche, with the date and value at vesting.
3. Your final pay stub showing year-to-date wages, Social Security, Medicare and withholding.
4. Carry statements, the carry or partnership agreement, and any 83(b) election with proof of filing.
5. Co-invest and employee-fund statements, the buyback terms, and a contact for K-1s.
6. Your separation agreement, with garden-leave, non-compete and severance terms.
7. The new firm's offer letter, with make-whole, vesting and clawback terms.
8. A record of where you worked each day, if you are also moving states.
9. A current mailing address on file with the old firm's payroll and each fund's K-1 contact, because W-2s for later deferred pay or severance, and K-1s, keep coming after you leave.

Final K-1s often arrive late. If one is not in by the filing deadline, an extension avoids the late-filing penalty: a return more than 60 days late carries a minimum penalty of $535 or the tax due, if less. Form 4868 extends the filing date to October 15, but not the time to pay (Topic 304).

Example

Illustrative only, in US dollars. Each person is single.

Two employers and a make-whole

A portfolio manager leaves Fund A in June after $250,000 of wages there. Fund B pays $600,000 of wages for the rest of the year, of which $500,000 is a cash make-whole.

• Social Security. Each fund withholds 6.2% of $184,500, or $11,439. Total withheld: $22,878. The return credits back $11,439.
• Additional Medicare. Fund A withholds 0.9% of $50,000, or $450. Fund B withholds 0.9% of $400,000, or $3,600. The tax on $850,000 is 0.9% of $650,000, or $5,850, so $1,800 more is due with the return.
• Income tax. If Fund B has already withheld from a regular paycheck, it may withhold a flat 22% on the $500,000 make-whole, or $110,000, which can be well below the tax on it. If it pays the make-whole before any regular paycheck, it adds it to regular wages and withholds on the total instead.

Forfeited and accelerated tranches

A $300,000 deferred bonus vests in three $100,000 tranches. The first vested last year, with Social Security and Medicare taken then.

• Resigns. Tranches two and three are forfeited: no income, no Social Security or Medicare, and no refund of what was taken on tranche one.
• Let go without cause, plan accelerates. Tranches two and three vest on the exit date, so Social Security (up to the wage base) and Medicare apply to $200,000 then. If the plan pays them next year, they are income next year.

Severance over two years

A vice president is let go in October with $120,000 of severance, $40,000 paid in December and $80,000 the next year. The $40,000 is wages this year and the $80,000 is wages next year, each with Social Security, Medicare and withholding.

Different for you?

• You moved states before the payments arrived. Your old state may still tax deferred pay, severance and non-compete pay: see State tax on deferred pay after a move and Fund manager moving to Florida or Texas.
• You must repay a sign-on bonus or make-whole. See Repaying a bonus you were taxed on.
• You were a partner of the management company or general partner. See Becoming a partner at a fund manager and Buying out a partner.
• You are leaving the US, not just the fund. See Leaving the US.
• You are moving to Canada with deferred pay or awards. See Stock awards and pay after a move.
• Your return will carry W-2s from two firms plus carry and co-invest K-1s. See Choosing a CPA for many fund investments.
• A make-whole, accelerated vesting or a below-value buyback in the same year. The amounts interact across two W-2s and several K-1s; see tax work for fund employees.