Many companies have implemented severance plans due to the current economic situation. While companies typically consider the employment law implications of severance plans (such as the Age Discrimination in Employment Act), many have not considered how these plans are governed by the Internal Revenue Code of 1986, as amended (the “Code”) and the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). This article briefly summarizes how the Code and ERISA govern severance plans.
Code section 409A (“Section 409A”) became law on January 1, 2005. While many people think Section 409A applies only to traditional deferred compensation plans, a severance plan will be considered a deferred compensation plan (and will be covered by Section 409A) unless a specific exception applies. In general, Section 409A contains strict limitations on several aspects of severance plans, including, but not limited to, the following:
- Elections to defer compensation
- The time and form of payment
- The ability to change the time and form of payment
Failure to comply with its requirements can result in incredibly high taxes for affected employees. This includes, in addition to regular income taxes and interest, a 40% excise tax for employees who reside in California, and a 20% excise tax for employees who reside in other states.
Common Exceptions to Section 409A
There are five commonly used exceptions under Section 409A for severance plans:
- The short-term deferral rule
- Limited separation pay upon an involuntary separation from service or pursuant to a window program
- Certain collectively bargained plans
- Non-taxable benefits
- Certain reimbursement arrangements
A brief summary of each of these exceptions follows.
Short-Term Deferral Rule
Under the short-term deferral rule, any amount paid under a severance plan is not deferred compensation if an employee actually or constructively receives payment of the entire amount by the later of:
- 2½ months from the end of the employee’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or
- the date that is 2 ½ months from the end of the employer’s taxable year in which the amount is no longer subject to a substantial risk of forfeiture.
The regulations under Section 409A make it clear that if it is possible to make the payment after the above deadline, then the short-term deferral rule does not apply.
For example, assume that the employer and an employee entered into a severance agreement on November 1, 2009, which states that the employee would receive cash compensation when he terminated from employment (i.e., he had a walk-away right to severance payments). Also assume that both the employee’s taxable year and the employer’s taxable year are the calendar year. There is no substantial risk of forfeiture because the employee will receive the amounts when he terminates employment. In this case, because we do not know when the employee will terminate employment, payment could occur long after March 15, 2010 (i.e., long after 2 ½ months from the end of the employee’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture). Accordingly, the short-term deferral rule would not apply to this plan.
Severance payments that are contingent on the employee executing a general release can also run afoul of the short-term deferral rule. Assume that the employer and the employee enter into a severance agreement on December 1, 2009 (the day prior to the date the employee was to terminate) and payments are to be made to the employee within 30 days of termination, subject to the employee executing a general release. If the agreement does not contain a deadline for signing the general release, the payment would not meet the requirements of the short-term deferral rule since it is possible for the employee to sign and deliver the general release after March 15, 2010 (i.e., past 2 ½ months from the end of the employee’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture).
Lastly, for publicly traded companies, there are special considerations for employees classified as key employees under Section 409A. For those employees, there is a requirement that any payment be delayed for six-months if the payment triggering event is a separation from service. This article does not discuss those rules.
Involuntary Separation or Window Program
Severance pay is exempt from Section 409A if all of the following requirements are met:
- The plan must provide only for separation pay upon an involuntary termination or pursuant to a window program
- The severance pay must not exceed two times the lesser of:
- the employee’s annualized compensation based on the annual rate of pay for services provided to the employer for the taxable year preceding the separation; or
- the maximum amount that may be taken into account under a qualified plan pursuant to Code Section 401(a)(17) for the year in which the separation occurs ($245,000 for 2009)
- All payments must be made by the end of the second taxable year of the employee following the year in which the separation occurs
Involuntary termination means a separation from service due to the independent exercise of unilateral authority of the employer to terminate the employee, other than due to the employee’s implicit or explicit request, where the employee was willing and able to continue performing services. In addition, a “good reason” termination may be treated as an involuntary termination, so long as the definition of good reason in the plan meets the requirements in the regulations under Section 409A.
While this exemption would seem to apply to most involuntary severance plans, there are still common severance plan designs that fail to come within this exemption. For example, if the employee was entitled to the severance benefit for reasons other than involuntary separation (such as at retirement, disability or death), the exemption would not apply. In addition, if an employee was hired and fired in the same year, his annual compensation from the employer for the prior year would be zero. Under a strict reading of the rule, the severance pay made to that employee would not qualify.
Certain Collectively Bargained Plans
An exception from Section 409A applies to collectively bargained severance plans that only provide for severance pay upon an involuntary separation from service or pursuant to a window program. Only the portion of the plan attributable to employees covered by a bona fide collective bargaining agreement is eligible for the exception.
The Section 409A regulations clarify that a legally binding right to receive a nontaxable benefit is not subject to Section 409A. The IRS has informally indicated that this exemption can be used if the employer pays for all or a portion of health benefits for the employee for a period of time past separation of service. However, if the employer-paid extension of benefits is provided under a self-funded health plan, that benefit could be taxable because it violates the non-discrimination rules under Code section 105(h). In that case, this exemption would not apply.
Certain Reimbursement Arrangements
An employee may be entitled to reimbursement of certain expenses following a separation from service. This right of reimbursement is not subject to a substantial risk of forfeiture, so a delay (past the short-term deferral period) in paying the reimbursement could result in a deferral of compensation. The Section 409A regulations contain an exception for certain reimbursements that occur in connection with a separation from service. These reimbursements include:
- amounts the employer could otherwise deduct under Code Sections 162 or 167;
- reasonable outplacement expenses and reasonable moving expenses;
- certain in-kind benefits; and
- taxable medical expenses incurred and paid for by the employee.
With the exception of taxable medical expenses, the expenses described above must be incurred or the benefits provided by the end of the second year following the year in which the separation from service occurs, and all reimbursements must be paid by the end of the third year. For taxable medical expenses described above, this exemption applies to the extent that the reimbursement rights apply during the period of time the employee would be entitled to COBRA continuation coverage.
For example, if the severance plan provides for outplacement services, those services must be provided to the employee by the end of the second year following the year in which the separation from service occurs and all reimbursements must be paid by the end of the third year.
Many severance plans are covered by ERISA. These plans are either characterized as welfare plans or pension plans under ERISA, and different rules govern the two types of plans.
Severance Plan Subject to ERISA
Section 3(1) of ERISA defines an employee benefit plan as, among other things, “any plan, fund, or program … established or maintained by an employer … for the purpose of providing for its participants or their beneficiaries … any benefit described in section 186(c) of this title.” Severance benefits are among those benefits described in section 186(c).
A key case that analyzes whether a severance arrangement is an ERISA plan is Fort Halifax Packing Co. v. Coyne, decided by the United States Supreme Court in 1987. At issue in Fort Halifax was whether a Maine statute that required employers to provide their employees with a one-time severance payment under certain circumstances established an ERISA plan. The Supreme Court held that in order for an arrangement to be subject to ERISA, the administration of the arrangement must require “an ongoing administrative program to meet the employer’s obligation.” The court went on to state that the “requirement of a one-time, lump-sum payment triggered by a single event requires no administrative scheme whatsoever.”
Relying on the Fort Halifax decision, courts have looked at the following factors in determining whether an arrangement providing severance payments is an ERISA plan:
- Whether the severance payments made pursuant to the arrangement are subject to an “ongoing administrative scheme” for determining the eligibility to receive severance benefits and/or the calculation of such benefits
- Whether the employer is required to exercise discretion in determining the eligibility to receive the severance benefits
Most severance plans are found by courts to require sufficient discretion — in determining when severance benefits are payable or in identifying which employees are eligible — to be ERISA-covered plans. This can occur in plans where the employer has to calculate years of service as well as plans where employees are provided extended benefits (rather than a one time payment).
Welfare Plan or Pension Plan under ERISA
As stated above, a severance plan that is subject to ERISA will be classified as either a pension benefit plan or a welfare benefit plan. Welfare benefit plans are subject to significantly fewer ERISA requirements than pension plans. According to Department of Labor (the “DOL”) regulations, in order for a severance plan to be a welfare benefit plan under ERISA, all of the following requirements must be met:
- The severance plan payment may not be contingent, directly or indirectly, upon the employee retiring
- The total amount of the payments to be made may not exceed two times the employee’s annual compensation during the last full year of employment
- All payments must be made within 24 months following the employee’s termination
If a severance plan is a welfare benefit plan, then ERISA’s reporting and disclosure requirements, fiduciary responsibility provisions, and administration and enforcement provisions apply. As described in the next section, this could include (among other things) filing an annual return with the Department of Labor. If the severance plan is a pension benefit plan, in addition to the requirements of ERISA with which welfare benefit plans must comply it must comply with ERISA’s funding, vesting and participation standards. This could include (among other things) requirements that a trust be maintained for the plan and that the plan not contain any forfeiture provisions.
Some Requirements under ERISA
The requirements that apply to both welfare and pension plans include, but are not limited to, the following:
- The severance plan must be in writing and provide claims procedures for employees and beneficiaries. This can be an issue when an employer has a past practice of paying severance benefits, but has never memorialized that practice into a plan document.
- The severance plan must file an annual Form 5500, unless the plan has fewer than 100 participants and any benefits are paid by an insurance company or out of general assets. It should be noted that for Form 5500 purposes, an employer must count as a “participant” every employee who could be entitled to the benefits if he or she were terminated — not simply those who were in fact terminated. For example, if a company’s severance plan covered all full-time employees who were involuntarily terminated, and the employer employs 200 employees but only terminated 12 in a year, the plan would be considered to have 200 participants. Hence, it would be required to file a Form 5500.
- All participants who receive a benefit under the plan must be provided with a summary plan description of the severance plan. This document must be written in plain English and contain all of the language required by ERISA, such as a statement of ERISA rights.
Potential Penalties under ERISA
ERISA contains both civil and criminal penalties for failing to meet certain requirements, such as the following:
- Monetary penalties for failing to provide a summary plan description to a participant when requested by the participant (up to $110 per day, per violation)
- Monetary penalties for failing to file an annual Form 5500 (up to $1,100 per day)
- Criminal penalties for willful violations of ERISA’s reporting and disclosure requirements
Ability to Amend or Terminate the Plan
As stated above, ERISA requires that a plan be in writing. While this may seem like a burden, there are corresponding advantages. Having a plan document allows the employer to add a provision that the plan can be amended or terminated at any time. Several cases have found that where an employer handles its severance matters on an informal basis, the employer’s past practices provide a basis for terminated employees to make a claim or sue for those severance benefits if they did not receive them. Accordingly, a plan document that contains the right to terminate or amend the plan at any time is a protection against such claims.
In addition, there are several other advantages to having an ERISA plan, including, but not limited to:
- If the plan follows its ERISA claims procedures, the court will overturn the employer’s decision only if the employer acted in an arbitrary and capricious manner
- The employee has no right to a jury trial
- No punitive damages can be assessed against the employer
While an employer has a great deal of discretion in how it designs its severance plan, it must be aware of potential issues under the Code and ERISA. Once aware of these issues, an employer should be able to draft a plan that meets its objectives and applicable legal requirements.
This article is a summary of these issues. Trucker Huss hosted a webcast on September 1 that discusses these issues in greater detail. If you were unable to listen to the live version of the webcast, a full recording and the materials are posted on this website.