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Severance benefits are payments made to employees upon termination of employment caused by events that are beyond their control, such as workforce reductions, plant closings, company takeovers, and mergers. Severance benefits are sometimes offered to encourage early retirement or voluntary resignation, or to discourage terminated employees from suing an employer. Severance benefits are not required by federal law and are required only by a handful of states. However, most companies offer severance pay. The payments themselves may be a one-time occurrence or spread over a period of time. These benefits are usually calculated by the employee's length of service with the company (e.g., one week of severance pay given for every year employed with the company).
Another severance benefit often offered by companies is outplacement counseling. This can be provided in the form of résumé assistance, job placements, and career counseling. Outplacement counseling is designed to help terminated employees prepare themselves for a new job or a new career, to lend assistance in providing outside resources to provide training, and to generally help employees cope with leaving the company. Larger organizations may hire outplacement services to assist employees, whereas smaller organizations may hire a single counselor or use existing resources to assist employees.
Employers may offer a voluntary severance program in lieu of laying off employees. This allows an employer to encourage employees it does not want to retain to accept a severance package. However, a risk associated with a voluntary severance program is that more valuable employees that the employer would like to retain may choose to accept the severance. A typical voluntary severance program pays an employee one to two weeks' salary per year of service.
It is important for an employer to determine whether the severance program it chooses to offer will be covered by the Employee Retirement Security Act (ERISA), and if it is, whether the plan is a pension benefit plan or a welfare benefit plan. Severance programs not covered by ERISA are subject to very little regulation. Welfare benefit plans primarily must comply with ERISA's fiduciary, reporting and disclosure, and claims procedure requirements. Pension benefit plans must comply with additional ERISA requirements, including minimum participation and vesting rules. Please see the national ERISA section.
Most formal, written severance packages are covered by ERISA. Informal severance practices may also be covered by ERISA.
A federal appeals court has set out a four-factor test to determine whether an informal practice is governed by ERISA (Donovan v. Dillingham, 688 F.2d 1367 (1982)). In order to be an ERISA-covered plan, the court said, a “reasonable person” must be able to decide:
• What are the intended benefits?
• Who are the intended beneficiaries?
• What is the source of financing?
• What are the procedures for receiving benefits?
If a reasonable person can accurately answer these questions based on the surrounding circumstances, the plan is governed by ERISA. Where employers have followed a consistent practice in applying eligibility criteria and a specific benefit formula in awarding severance pay, there is a strong possibility that the plan is governed by ERISA. Also, if the severance plan requires administrative involvement for a benefits payout over time, ERISA will probably also govern. A one-time lump sum payment is generally not considered an ERISA plan because it requires no procedures for determining benefits.
ERISA requires that a covered severance plan:
• Be in writing.
• Describe how payments will be made.
• Provide for one or more named fiduciaries to manage and control the plan.
• Provide a funding policy.
• Provide a procedure for amending the plan.
• Distribute a summary plan description (SPD) to plan participants.
• Include a claims procedure.
The SPD must be provided to all eligible employees and must include the following:
• Information about eligibility requirements, the basis for payments to participants, the plan sponsor, the plan administrator, the agent for service of legal process, the procedure for amending the plan, the plan year, and the plan's identification number
• A statement of employees' rights under ERISA (to obtain and examine documents and the ability to sue)
• A claims review procedure for employees who are denied benefits and wish to appeal
In addition, if a severance plan is governed under ERISA, the plan fiduciary or administrator must file a Form 5500 (Report of Employee Benefit Plan) with the federal U.S. Department of Labor. Failure to do so could result in very harsh fines, and willful failure to do so may subject an employer to criminal liability. Please see the national Welfare and Pension Reports section.
ERISA generally treats deferred compensation as a pension plan. DOL regulations (29 CFR 2510.3-2), however, provide that a severance arrangement will not be treated as an employee pension benefit plan because the payment of severance benefits is on account of the termination of an employee's service if the following requirements are also satisfied:
• The payments are not contingent, directly or indirectly, upon the employee's retiring;
• The total amount of such payments does not exceed the equivalent of twice the employee's annual compensation during the year immediately preceding the termination of his service; and
• All the payments to any employee are completed within specified time limits.
The time limits for completion of severance payments for an arrangement to be treated as a welfare plan are:
• In the case of an employee whose service is terminated in connection with a limited program of terminations, within the later of 24 months after the termination of the employee's service, or 24 months after the employee reaches normal retirement age; and
• In the case of all other employees, within 24 months after the termination of the employee's service.
A "limited program of terminations" is a program that, when begun, was scheduled to be completed on a date certain or on the occurrence of one or more specified events under which the number, percentage, or class or classes of employees whose services were to be terminated was specified in advance. There must be a written document that contains information sufficient to demonstrate that the required conditions have been met.
To keep the cost of an early retirement incentive program down, employers will not want the fact that such a plan is under consideration to be disclosed. ERISA, however, requires that plan fiduciaries perform their duties solely in the interest of the participants and beneficiaries, and this has been interpreted as requiring that participants and beneficiaries be provided with accurate information about the “likely future of plan benefits.” Thus, courts have ruled that questions from plan participants about an employer's plans to offer enhanced severance or retirement benefits must be communicated as soon as the proposal is given “serious consideration” by the employer. In the leading case on the subject (Fischer v. Philadelphia Electric. Co., 96 F.3d 1533, 1996), the 3rd Circuit Court of Appeals set out a standard for determining when a proposal is under “serious consideration.” Serious consideration takes place when “(1) a specific proposal (2) is being discussed for purposes of implementation (3) by senior management with the authority to implement the change.”
The first requirement distinguishes serious consideration from the preliminary process of gathering information, developing strategies, and analyzing options. The second element distinguishes an analysis of alternatives from the process of implementing an actual change. And the final element focuses the analysis of serious consideration on the proper people in a corporate hierarchy. While discussions about implementing benefit changes go on at many levels in an organization, serious consideration doesn't start until the members of senior management with responsibility for making recommendations to the board of directors on benefits take up the issue.
For most companies, only salary payouts are included in the severance arrangement, but some participants may provide health and welfare benefits, accelerated vesting of company stock, reallocation services, and supplemental executive retirement plans as part of their severance package. These benefits generally last for the same length of time as the salary payments. Employers may also be required to offer continued health care benefits under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). Please see the national Health Insurance Continuation/COBRA section.
Under the Federal Insurance Contributions Act (FICA), employers and employees contribute a certain percentage of an employee’s earnings (up to a “maximum taxable earnings” amount that is determined annually) during the year for Social Security and a certain percentage of all taxable earnings for Medicare. Different rates apply for each of these taxes (i.e., one rate for the Social Security tax and one rate for the Medicare tax).
Whether severance pay is subject to FICA taxes has often been a source of confusion for employers. However, the U.S. Supreme Court clarified the issue in U.S. v. Quality Stores, Inc.(No. 12-1408, U.S. S.Ct., 2014), holding that generally, severance pay is subject to FICA tax withholding. Thus, employers must ensure they are aware of this development and are withholding FICA taxes from applicable severance payments.
Internal Revenue Code (IRC) Sec. 409A sets out rules for nonqualified deferred compensation (NQDC). Severance pay is included in the definition of NQDC unless a specific exemption applies.
409A coverage. Sec. 409A defines "NQDC" as compensation that workers earn in one year but that is not paid until a future year to the extent that the compensation is not subject to a substantial risk of forfeiture and not previously included in gross income. A plan is treated as providing for a payment to be made in a subsequent year whether the plan explicitly so provides or the deferral condition is inherent in the terms of the contract. For example, if a plan provides a right to a payment upon separation from service, the plan generally will result in a deferral of compensation regardless of whether the employee separates from service and receives the payment in the same year, because under the plan the payment is conditioned upon an event that may occur after the year in which the legally binding right to the payment arises. Sec. 409A does not apply to qualified plans (such as a 401(k) plan) or to a 403(b) plan or a 457 plan.
Tax penalties. If deferred compensation covered by Sec. 409A meets the specified requirements, there is no effect on the employee’s taxes. The compensation is taxed in the same manner as it would be taxed if it were not covered by Sec. 409A. If the arrangement does not meet the requirements, the compensation is subject to certain additional taxes, including a 20 percent additional income tax.
Exception for certain types of separation pay. IRS regulations (IRS Reg. Sec. 1.409A-1) provide exceptions from coverage under Sec. 409A for:
• Certain bona fide collectively bargained arrangements;
• Certain arrangements providing separation pay due solely to an involuntary separation from service or participation in a window program in limited amounts and for a limited period of time;
• Certain foreign separation pay arrangements;
• Certain reimbursement arrangements providing for expense reimbursements or in-kind benefits for a limited period of time following a separation from service; and
• Certain rights to limited amounts of separation pay.
These exceptions from coverage for specified separation pay plans may be used in combination.
Window program. A "window program" is a program established by an employer in connection with an impending separation from service to provide separation pay that is made available for a limited period of time (no longer than 12 months) to employees who separate from service during that period or to employees who separate from service during that period under specified circumstances. A program is not a window program if an employer establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time. Whether the recurrence of these programs constitutes a pattern is determined on the basis of the facts and circumstances. Relevant factors include whether the benefits are on account of a specific business event or condition, the degree to which the separation pay relates to the event or condition, and whether the event or condition is temporary or discrete or is a permanent aspect of the employer’s business.
Involuntary separation from service exception. The exception from coverage under Sec. 409A for rights to payments available only upon an involuntary separation from service or participation in a window program applies to amounts payable no later than the end of the second taxable year of the employee following the year of the separation from service. The payment must be limited to an amount that is generally the lesser of two times the service provider’s annual compensation or two times the limit on compensation set in IRC Sec. 401(a)(17) that is $225,000 during 2007. The exclusion does apply to payments up to the limit, even when the entire amount of the separation payments exceeds the limit. The right to the payment up to the applicable limit will not be subject to Sec. 409A, including the requirement that the payment be delayed for 6 months in the case of a specified employee, provided that such limited payment is otherwise required to be made, and is made, no later than the end of the second taxable year following the service provider’s taxable year in which the separation from service occurs.
This exception does not apply to a plan providing for a payment on a voluntary separation from service or other event.
Definition of an "involuntary separation from service." Whether a separation from service is involuntary is determined based on all the facts and circumstances. Any characterization of the separation from service as voluntary or involuntary by the employee and the employer in the documentation relating to the separation from service is rebuttably presumed to properly characterize the termination. For example, if a separation from service is characterized as voluntary, the presumption may be rebutted by demonstrating that if the employee had not voluntarily resigned, the employer would have terminated him or her. If the right to a payment is contingent on a voluntary separation from service following an occurrence that constitutes good reason for termination of the employee's services, the right may be treated as payable only on an involuntary separation from service. An involuntary separation may not be devised in order to avoid the requirements of Sec. 409A.
Safe harbor for good-reason voluntary separations. IRS regulations also provide a safe harbor under which a provision for a payment on a voluntary separation from service for good reason will be treated as providing for a payment on an actual involuntary separation from service. Those conditions include that:
• The amount is payable only if the employee separates from service within a limited period of time not to exceed 2 years following the initial existence of the good-reason condition;
• The amount, time, and form of payment on a voluntary separation from service for good reason is identical to that for a payment on an involuntary separation from service;
• The employer provide notice of the existence of the good-reason condition within 90 days of its initial existence; and
• The employee is provided a period of at least 30 days during which it may remedy the good-reason condition.
A good-reason condition may consist of one or more of the following conditions arising without the consent of the employee:
• A material reduction in the employee's base compensation;
• A material reduction in the employee's authority, duties, or responsibilities;
• A material reduction in the authority, duties, or responsibilities of the employee's supervisor, including a requirement that a supervisor report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation or similar entity for organizations that are not corporations;
• A material reduction in the budget over which the employee retains authority;
• A material change in geographic location at which the employee must work; or
• Any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.
Tax exempt benefits. IRS regulations provide that a right to a benefit that is excludable from income will not be treated as a deferral of compensation for purposes of Sec. 409A. Accordingly, for example, an arrangement to provide health coverage excludable from income under IRC Sec. 105 generally would not be subject to Sec. 409A.
Outplacement services and moving expenses. The reimbursement of certain expenses such as reasonable outplacement expenses and reasonable moving expenses for a limited period of time due to a separation from service is not covered by Sec. 409A, whether the separation from service is voluntary or involuntary. The expense must be incurred by the employee no later than the end of the second year following the year in which the separation from service occurs. The period during which an employee can receive a reimbursement payment is extended to the end of the third year following the separation from service for reimbursements of expenses incurred by the employee. Reasonable moving expenses include a reimbursement for a loss incurred selling a primary residence.
Limited payments of separation pay. If not otherwise excluded, a taxpayer may treat (as excepted from 409A coverage) a right or rights under a separation pay plan to a payment or payments of less than the maximum amount of an elective deferral permitted to a 401(k) plan under IRC 402(g) for the year of the separation from service. The limited payment exception is intended to avoid the application of Sec. 409A to incidental benefits often provided on a separation from service where the parties may not realize that the benefits are nonqualified deferred compensation. The exclusion may be applied to any type of separation pay plan but may apply only once with respect to amounts paid by a service recipient to a service provider.
A NQDC plan or arrangement that does not qualify for an exception must be in writing and satisfy requirements for:
• The initial deferral election,
• The timing of payments to the employee,
• Acceleration of payments, and
• Subsequent deferral elections.
The material terms of the plan must be specified in the plan document, and the plan must be operated in accordance with the document. The material terms of the plan include the amount (or the method or formula for determining the amount) of deferred compensation, the time and form of payment, the 6-month payment delay for “key employee” of public companies (if applicable), and the conditions that apply to any employee elections.
Initial deferral election. In general, an employee must be required to make the initial election to defer compensation before the year in which the services are performed for which the compensation is earned. In an employee’s first year of eligibility under an NQDC plan or arrangement, he or she may make a deferral election in the first 30 days of participation. However, the election may apply only to compensation earned after the election was made. A special provision applies in the case of an election to defer performance-based compensation that is based on services performed over 12 months or more. In such a case, the election must be made no later than 6 months before the end of the performance period.
Timing of payments. Sec. 409A requires that payments of deferred compensation be made at a specified time or under a fixed schedule that is objectively determinable, or upon the following events: separation from service, death, disability, change in the ownership or effective control of the service recipient, or unforeseeable emergency, as these events are defined in the Sec. 409A regulations.
Anti-acceleration rule. Payments under an NQDC plan or arrangement generally may not be accelerated. Accelerated payments that are necessary to comply with a domestic relations order or conflict-of-interest rules, and upon certain plan terminations, may be permitted.
Subsequent deferral elections. An NQDC plan that permits an employee to elect to delay or change the form of a payment must meet the following conditions: (1) the election may not take effect until at least 12 months after the date on which it was made; (2) if the election relates to a payment that is not made on account of death, disability, or unforeseeable emergency, the first payment elected must be deferred for at least 5 years; and (3) any election related to a payment at a specified time or under a fixed schedule may not be made less than 12 months before the date of the first scheduled payment.
Effective dates. IRS has granted employers an extension to January 1, 2009 to comply with the Sec. 409A regulations that require all nonqualified deferred compensation plans be in writing and that plan documents be brought into compliance with the law and regulations.
The $1 million per year limit on the deductibility of compensation paid to the chief executive officer or one of the four highest paid officers of a publicly held corporation does not include “remuneration payable solely on account of attainment of one or more performance goals” (IRC Sec. 162(m)(4)(C)). However, a payment won't qualify for this exemption as a performance bonus even though the plan or agreement under which the covered employee is paid provides that the compensation will be paid upon attainment of a performance goal if it also provides that the compensation will be paid without regard to whether the performance goal is attained if the covered employee’s employment is involuntarily terminated without cause or the covered employee terminates his or her employment for good reason or retires (Rev. Rul. 2008-13).
An employer and employee may agree to waive severance pay as long as the employee is knowingly and voluntarily waiving any future claims.
The Age Discrimination in Employment Act of 1967 (ADEA) prohibits employers from discriminating against employees on the basis of age. Employers cannot offer severance pay to only one age group without violating the ADEA.
Waiver of age discrimination claims. Employers often ask employees to waive age discrimination claims in exchange for severance pay. The Older Workers' Benefit Protection Act (OWBPA) dictates that employees over 40 can waive age discrimination claims under the ADEA if those waivers are knowing and voluntary and comply with the requirements of the OWBPA. To be valid, the waivers should:
• Be in writing.
• Be written in plain language and geared to the level of understanding of the individual or typical participant signing the waiver.
• Not contain long, complex sentences or technical or legal jargon.
• Not mislead, misinform, or fail to inform participants of the waiver's benefits and limitations.
• Specifically mention, by name, every claim the employee is giving up.
• Not attempt to waive rights or claims arising after the waiver is signed.
• Provide something of value, beyond that to which the employee would have already been entitled (such as enhanced severance or any severance).
• Advise the employee to consult an attorney before signing.
• Give the employee 21 days to decide whether to sign the waiver. If the severance is connected to a termination program offered to a group of employees, that time period increases to 45 days (29 USC 1625).
If these conditions are not met, the agreement may not be enforceable. This means that the employee may still be able to bring a claim for age discrimination. In addition, employers must allow for a 7-day period after the waiver is signed during which the employee can revoke his or her decision (29 USC Sec. 626 (f)(1)). Employers should ensure that their waiver agreements and employment practices comply with the requirements of the OWBPA. Please see the national Age Discrimination section.
Must severance pay be returned if the agreement is invalid? The U.S. Supreme Court has ruled that a discharged employee does not have to return severance pay already received if the waiver signed did not comply with the OWBPA (Oubre v. Entergy Operations, Inc., 522 U.S. 422 (1998)).
Strict informational requirements. The EEOC requires that if the release is in connection with an exit incentive program or other termination program that applies to a group or class of employees, employers must provide all eligible participants with:
• The class, unit, or group of persons covered by the program; eligibility factors; and applicable time limits of the program;
• Job titles and ages of those individuals eligible for the program; and
• The ages of those individuals in the same “job classification or organizational unit” who are not eligible or were not selected for the program.
Employees may or may not be entitled to receive unemployment compensation at the same time they are receiving severance benefits. This is a state-specific area.
Please see the state Unemployment Compensation section.
As long as benefits are not required by state law, an employer may amend its severance policy or eliminate it altogether. Rights to severance benefits do not vest. The key is to make certain that the amendments to the severance policy or elimination of the policy are published and that all employees receive notice of the changes made.
Every business should have established guidelines concerning severance pay. Such a policy not only provides employees with guidelines, but also protects the employer from lawsuits based on claims of unfair business practices. Severance policies will vary according to an employer's needs. To institute a severance policy that is right for you, consider including sections that address:
Rationale. Briefly state the reason for granting severance pay.
Eligibility. Who is eligible to receive severance pay? Are only actively, regularly employed individuals eligible? Are employees covered by collective bargaining agreement or employees who have an individual written employment contract covered? Are employees who are terminated for gross misconduct eligible? What events qualify an individual for severance pay? Does discharge for poor job performance qualify an individual? Does layoff due to a reorganization qualify? Does termination due to elimination of a position? What if the person obtains another position within the company, a related company, or the company acquiring the business? As stated earlier, eligibility is usually limited to employees whose termination has been initiated by the company. Be sure to mention any other limitations regarding eligibility.
Payment schedule. If the amount of severance pay is linked to length of service, explain how it is determined. Is the amount of severance pay based on a base salary, a bonus, overtime, or other compensation? Will there be any amounts deducted from the severance pay?
Coordination with other benefits. Will the amount of severance pay be increased or decreased as a result of other benefits? For example, will someone who is on disability be eligible for severance pay? If disability pay ends because a job is eliminated, does the person then receive severance pay? Is severance pay reduced by any amount payable because of a competing state law?
Exceptions. If there are some groups of employees who receive different treatment or who will be handled on an individual basis (e.g. high level executives), say so.
Terminology. Keep in mind that a former employee's eligibility for unemployment benefits may be affected by the terminology used for “severance pay” or “pay in lieu of notice.” When using the term “severance pay,” unemployment offices may view the individual as being immediately eligible for unemployment benefits. In contrast, using the term “pay in lieu of notice” may qualify the individual for unemployment benefits until the end of the period for which the pay is intended.
When payment will be received. Will the employee receive his or her severance pay on the last day of work, or will it be mailed to his or her home at a later date? Will the pay be provided on a regularly scheduled payday? Will the payment be made over time (i.e., 3 months' severance pay paid over 6 months)? Keep in mind when deciding to pay severance that the cooperation of the employee may be needed for sometime after he or she leaves.
Maximums and minimums. Regardless of the formula for severance pay, it is a good idea to establish a maximum and a minimum for it. There may be exceptions to this where employers will want to pay more or less than those amounts. For example, an employer may want to increase severance pay beyond the normal rate if an employee asserts a discrimination claim against the company. In contrast, employers may not want to pay severance pay to an employee caught stealing.
Releases. As a condition for the payment of severance benefits, employers may require the individual to release them from any claims, such as violations of any discrimination law. Care should be taken to ensure that such a release is binding and enforceable.
Noncompete. Employers may wish to provide that an employee accepting severance pay cannot compete with them for a specific amount of time. This period may be linked to the amount of the severance pay or its duration.
Before committing the policy to writing, employers should also give careful consideration to:
The company's ability to pay. Is a large-scale payoff possible in the future? Would the company be able to pay each of the individuals who loses his or her job the promised severance pay? Many companies make the mistake of considering only individual separations when they draw up their policy on severance pay, and neglect to consider what it might cost the company in the unforeseen event that a large number of employees have to be terminated at the same time.
Relevant union contract provisions. If the company is unionized, severance pay may be a matter requiring negotiation. Review relevant portions of the contract before you write the policy.
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National
Severance benefits are payments made to employees upon termination of employment caused by events that are beyond their control, such as workforce reductions, plant closings, company takeovers, and mergers. Severance benefits are sometimes offered to encourage early retirement or voluntary resignation, or to discourage terminated employees from suing an employer. Severance benefits are not required by federal law and are required only by a handful of states. However, most companies offer severance pay. The payments themselves may be a one-time occurrence or spread over a period of time. These benefits are usually calculated by the employee's length of service with the company (e.g., one week of severance pay given for every year employed with the company).
Another severance benefit often offered by companies is outplacement counseling. This can be provided in the form of résumé assistance, job placements, and career counseling. Outplacement counseling is designed to help terminated employees prepare themselves for a new job or a new career, to lend assistance in providing outside resources to provide training, and to generally help employees cope with leaving the company. Larger organizations may hire outplacement services to assist employees, whereas smaller organizations may hire a single counselor or use existing resources to assist employees.
Employers may offer a voluntary severance program in lieu of laying off employees. This allows an employer to encourage employees it does not want to retain to accept a severance package. However, a risk associated with a voluntary severance program is that more valuable employees that the employer would like to retain may choose to accept the severance. A typical voluntary severance program pays an employee one to two weeks' salary per year of service.
It is important for an employer to determine whether the severance program it chooses to offer will be covered by the Employee Retirement Security Act (ERISA), and if it is, whether the plan is a pension benefit plan or a welfare benefit plan. Severance programs not covered by ERISA are subject to very little regulation. Welfare benefit plans primarily must comply with ERISA's fiduciary, reporting and disclosure, and claims procedure requirements. Pension benefit plans must comply with additional ERISA requirements, including minimum participation and vesting rules. Please see the national ERISA section.
Most formal, written severance packages are covered by ERISA. Informal severance practices may also be covered by ERISA.
A federal appeals court has set out a four-factor test to determine whether an informal practice is governed by ERISA (Donovan v. Dillingham, 688 F.2d 1367 (1982)). In order to be an ERISA-covered plan, the court said, a “reasonable person” must be able to decide:
• What are the intended benefits?
• Who are the intended beneficiaries?
• What is the source of financing?
• What are the procedures for receiving benefits?
If a reasonable person can accurately answer these questions based on the surrounding circumstances, the plan is governed by ERISA. Where employers have followed a consistent practice in applying eligibility criteria and a specific benefit formula in awarding severance pay, there is a strong possibility that the plan is governed by ERISA. Also, if the severance plan requires administrative involvement for a benefits payout over time, ERISA will probably also govern. A one-time lump sum payment is generally not considered an ERISA plan because it requires no procedures for determining benefits.
ERISA requires that a covered severance plan:
• Be in writing.
• Describe how payments will be made.
• Provide for one or more named fiduciaries to manage and control the plan.
• Provide a funding policy.
• Provide a procedure for amending the plan.
• Distribute a summary plan description (SPD) to plan participants.
• Include a claims procedure.
The SPD must be provided to all eligible employees and must include the following:
• Information about eligibility requirements, the basis for payments to participants, the plan sponsor, the plan administrator, the agent for service of legal process, the procedure for amending the plan, the plan year, and the plan's identification number
• A statement of employees' rights under ERISA (to obtain and examine documents and the ability to sue)
• A claims review procedure for employees who are denied benefits and wish to appeal
In addition, if a severance plan is governed under ERISA, the plan fiduciary or administrator must file a Form 5500 (Report of Employee Benefit Plan) with the federal U.S. Department of Labor. Failure to do so could result in very harsh fines, and willful failure to do so may subject an employer to criminal liability. Please see the national Welfare and Pension Reports section.
ERISA generally treats deferred compensation as a pension plan. DOL regulations (29 CFR 2510.3-2), however, provide that a severance arrangement will not be treated as an employee pension benefit plan because the payment of severance benefits is on account of the termination of an employee's service if the following requirements are also satisfied:
• The payments are not contingent, directly or indirectly, upon the employee's retiring;
• The total amount of such payments does not exceed the equivalent of twice the employee's annual compensation during the year immediately preceding the termination of his service; and
• All the payments to any employee are completed within specified time limits.
The time limits for completion of severance payments for an arrangement to be treated as a welfare plan are:
• In the case of an employee whose service is terminated in connection with a limited program of terminations, within the later of 24 months after the termination of the employee's service, or 24 months after the employee reaches normal retirement age; and
• In the case of all other employees, within 24 months after the termination of the employee's service.
A "limited program of terminations" is a program that, when begun, was scheduled to be completed on a date certain or on the occurrence of one or more specified events under which the number, percentage, or class or classes of employees whose services were to be terminated was specified in advance. There must be a written document that contains information sufficient to demonstrate that the required conditions have been met.
To keep the cost of an early retirement incentive program down, employers will not want the fact that such a plan is under consideration to be disclosed. ERISA, however, requires that plan fiduciaries perform their duties solely in the interest of the participants and beneficiaries, and this has been interpreted as requiring that participants and beneficiaries be provided with accurate information about the “likely future of plan benefits.” Thus, courts have ruled that questions from plan participants about an employer's plans to offer enhanced severance or retirement benefits must be communicated as soon as the proposal is given “serious consideration” by the employer. In the leading case on the subject (Fischer v. Philadelphia Electric. Co., 96 F.3d 1533, 1996), the 3rd Circuit Court of Appeals set out a standard for determining when a proposal is under “serious consideration.” Serious consideration takes place when “(1) a specific proposal (2) is being discussed for purposes of implementation (3) by senior management with the authority to implement the change.”
The first requirement distinguishes serious consideration from the preliminary process of gathering information, developing strategies, and analyzing options. The second element distinguishes an analysis of alternatives from the process of implementing an actual change. And the final element focuses the analysis of serious consideration on the proper people in a corporate hierarchy. While discussions about implementing benefit changes go on at many levels in an organization, serious consideration doesn't start until the members of senior management with responsibility for making recommendations to the board of directors on benefits take up the issue.
For most companies, only salary payouts are included in the severance arrangement, but some participants may provide health and welfare benefits, accelerated vesting of company stock, reallocation services, and supplemental executive retirement plans as part of their severance package. These benefits generally last for the same length of time as the salary payments. Employers may also be required to offer continued health care benefits under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). Please see the national Health Insurance Continuation/COBRA section.
Under the Federal Insurance Contributions Act (FICA), employers and employees contribute a certain percentage of an employee’s earnings (up to a “maximum taxable earnings” amount that is determined annually) during the year for Social Security and a certain percentage of all taxable earnings for Medicare. Different rates apply for each of these taxes (i.e., one rate for the Social Security tax and one rate for the Medicare tax).
Whether severance pay is subject to FICA taxes has often been a source of confusion for employers. However, the U.S. Supreme Court clarified the issue in U.S. v. Quality Stores, Inc.(No. 12-1408, U.S. S.Ct., 2014), holding that generally, severance pay is subject to FICA tax withholding. Thus, employers must ensure they are aware of this development and are withholding FICA taxes from applicable severance payments.
Internal Revenue Code (IRC) Sec. 409A sets out rules for nonqualified deferred compensation (NQDC). Severance pay is included in the definition of NQDC unless a specific exemption applies.
409A coverage. Sec. 409A defines "NQDC" as compensation that workers earn in one year but that is not paid until a future year to the extent that the compensation is not subject to a substantial risk of forfeiture and not previously included in gross income. A plan is treated as providing for a payment to be made in a subsequent year whether the plan explicitly so provides or the deferral condition is inherent in the terms of the contract. For example, if a plan provides a right to a payment upon separation from service, the plan generally will result in a deferral of compensation regardless of whether the employee separates from service and receives the payment in the same year, because under the plan the payment is conditioned upon an event that may occur after the year in which the legally binding right to the payment arises. Sec. 409A does not apply to qualified plans (such as a 401(k) plan) or to a 403(b) plan or a 457 plan.
Tax penalties. If deferred compensation covered by Sec. 409A meets the specified requirements, there is no effect on the employee’s taxes. The compensation is taxed in the same manner as it would be taxed if it were not covered by Sec. 409A. If the arrangement does not meet the requirements, the compensation is subject to certain additional taxes, including a 20 percent additional income tax.
Exception for certain types of separation pay. IRS regulations (IRS Reg. Sec. 1.409A-1) provide exceptions from coverage under Sec. 409A for:
• Certain bona fide collectively bargained arrangements;
• Certain arrangements providing separation pay due solely to an involuntary separation from service or participation in a window program in limited amounts and for a limited period of time;
• Certain foreign separation pay arrangements;
• Certain reimbursement arrangements providing for expense reimbursements or in-kind benefits for a limited period of time following a separation from service; and
• Certain rights to limited amounts of separation pay.
These exceptions from coverage for specified separation pay plans may be used in combination.
Window program. A "window program" is a program established by an employer in connection with an impending separation from service to provide separation pay that is made available for a limited period of time (no longer than 12 months) to employees who separate from service during that period or to employees who separate from service during that period under specified circumstances. A program is not a window program if an employer establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time. Whether the recurrence of these programs constitutes a pattern is determined on the basis of the facts and circumstances. Relevant factors include whether the benefits are on account of a specific business event or condition, the degree to which the separation pay relates to the event or condition, and whether the event or condition is temporary or discrete or is a permanent aspect of the employer’s business.
Involuntary separation from service exception. The exception from coverage under Sec. 409A for rights to payments available only upon an involuntary separation from service or participation in a window program applies to amounts payable no later than the end of the second taxable year of the employee following the year of the separation from service. The payment must be limited to an amount that is generally the lesser of two times the service provider’s annual compensation or two times the limit on compensation set in IRC Sec. 401(a)(17) that is $225,000 during 2007. The exclusion does apply to payments up to the limit, even when the entire amount of the separation payments exceeds the limit. The right to the payment up to the applicable limit will not be subject to Sec. 409A, including the requirement that the payment be delayed for 6 months in the case of a specified employee, provided that such limited payment is otherwise required to be made, and is made, no later than the end of the second taxable year following the service provider’s taxable year in which the separation from service occurs.
This exception does not apply to a plan providing for a payment on a voluntary separation from service or other event.
Definition of an "involuntary separation from service." Whether a separation from service is involuntary is determined based on all the facts and circumstances. Any characterization of the separation from service as voluntary or involuntary by the employee and the employer in the documentation relating to the separation from service is rebuttably presumed to properly characterize the termination. For example, if a separation from service is characterized as voluntary, the presumption may be rebutted by demonstrating that if the employee had not voluntarily resigned, the employer would have terminated him or her. If the right to a payment is contingent on a voluntary separation from service following an occurrence that constitutes good reason for termination of the employee's services, the right may be treated as payable only on an involuntary separation from service. An involuntary separation may not be devised in order to avoid the requirements of Sec. 409A.
Safe harbor for good-reason voluntary separations. IRS regulations also provide a safe harbor under which a provision for a payment on a voluntary separation from service for good reason will be treated as providing for a payment on an actual involuntary separation from service. Those conditions include that:
• The amount is payable only if the employee separates from service within a limited period of time not to exceed 2 years following the initial existence of the good-reason condition;
• The amount, time, and form of payment on a voluntary separation from service for good reason is identical to that for a payment on an involuntary separation from service;
• The employer provide notice of the existence of the good-reason condition within 90 days of its initial existence; and
• The employee is provided a period of at least 30 days during which it may remedy the good-reason condition.
A good-reason condition may consist of one or more of the following conditions arising without the consent of the employee:
• A material reduction in the employee's base compensation;
• A material reduction in the employee's authority, duties, or responsibilities;
• A material reduction in the authority, duties, or responsibilities of the employee's supervisor, including a requirement that a supervisor report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation or similar entity for organizations that are not corporations;
• A material reduction in the budget over which the employee retains authority;
• A material change in geographic location at which the employee must work; or
• Any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.
Tax exempt benefits. IRS regulations provide that a right to a benefit that is excludable from income will not be treated as a deferral of compensation for purposes of Sec. 409A. Accordingly, for example, an arrangement to provide health coverage excludable from income under IRC Sec. 105 generally would not be subject to Sec. 409A.
Outplacement services and moving expenses. The reimbursement of certain expenses such as reasonable outplacement expenses and reasonable moving expenses for a limited period of time due to a separation from service is not covered by Sec. 409A, whether the separation from service is voluntary or involuntary. The expense must be incurred by the employee no later than the end of the second year following the year in which the separation from service occurs. The period during which an employee can receive a reimbursement payment is extended to the end of the third year following the separation from service for reimbursements of expenses incurred by the employee. Reasonable moving expenses include a reimbursement for a loss incurred selling a primary residence.
Limited payments of separation pay. If not otherwise excluded, a taxpayer may treat (as excepted from 409A coverage) a right or rights under a separation pay plan to a payment or payments of less than the maximum amount of an elective deferral permitted to a 401(k) plan under IRC 402(g) for the year of the separation from service. The limited payment exception is intended to avoid the application of Sec. 409A to incidental benefits often provided on a separation from service where the parties may not realize that the benefits are nonqualified deferred compensation. The exclusion may be applied to any type of separation pay plan but may apply only once with respect to amounts paid by a service recipient to a service provider.
A NQDC plan or arrangement that does not qualify for an exception must be in writing and satisfy requirements for:
• The initial deferral election,
• The timing of payments to the employee,
• Acceleration of payments, and
• Subsequent deferral elections.
The material terms of the plan must be specified in the plan document, and the plan must be operated in accordance with the document. The material terms of the plan include the amount (or the method or formula for determining the amount) of deferred compensation, the time and form of payment, the 6-month payment delay for “key employee” of public companies (if applicable), and the conditions that apply to any employee elections.
Initial deferral election. In general, an employee must be required to make the initial election to defer compensation before the year in which the services are performed for which the compensation is earned. In an employee’s first year of eligibility under an NQDC plan or arrangement, he or she may make a deferral election in the first 30 days of participation. However, the election may apply only to compensation earned after the election was made. A special provision applies in the case of an election to defer performance-based compensation that is based on services performed over 12 months or more. In such a case, the election must be made no later than 6 months before the end of the performance period.
Timing of payments. Sec. 409A requires that payments of deferred compensation be made at a specified time or under a fixed schedule that is objectively determinable, or upon the following events: separation from service, death, disability, change in the ownership or effective control of the service recipient, or unforeseeable emergency, as these events are defined in the Sec. 409A regulations.
Anti-acceleration rule. Payments under an NQDC plan or arrangement generally may not be accelerated. Accelerated payments that are necessary to comply with a domestic relations order or conflict-of-interest rules, and upon certain plan terminations, may be permitted.
Subsequent deferral elections. An NQDC plan that permits an employee to elect to delay or change the form of a payment must meet the following conditions: (1) the election may not take effect until at least 12 months after the date on which it was made; (2) if the election relates to a payment that is not made on account of death, disability, or unforeseeable emergency, the first payment elected must be deferred for at least 5 years; and (3) any election related to a payment at a specified time or under a fixed schedule may not be made less than 12 months before the date of the first scheduled payment.
Effective dates. IRS has granted employers an extension to January 1, 2009 to comply with the Sec. 409A regulations that require all nonqualified deferred compensation plans be in writing and that plan documents be brought into compliance with the law and regulations.
The $1 million per year limit on the deductibility of compensation paid to the chief executive officer or one of the four highest paid officers of a publicly held corporation does not include “remuneration payable solely on account of attainment of one or more performance goals” (IRC Sec. 162(m)(4)(C)). However, a payment won't qualify for this exemption as a performance bonus even though the plan or agreement under which the covered employee is paid provides that the compensation will be paid upon attainment of a performance goal if it also provides that the compensation will be paid without regard to whether the performance goal is attained if the covered employee’s employment is involuntarily terminated without cause or the covered employee terminates his or her employment for good reason or retires (Rev. Rul. 2008-13).
An employer and employee may agree to waive severance pay as long as the employee is knowingly and voluntarily waiving any future claims.
The Age Discrimination in Employment Act of 1967 (ADEA) prohibits employers from discriminating against employees on the basis of age. Employers cannot offer severance pay to only one age group without violating the ADEA.
Waiver of age discrimination claims. Employers often ask employees to waive age discrimination claims in exchange for severance pay. The Older Workers' Benefit Protection Act (OWBPA) dictates that employees over 40 can waive age discrimination claims under the ADEA if those waivers are knowing and voluntary and comply with the requirements of the OWBPA. To be valid, the waivers should:
• Be in writing.
• Be written in plain language and geared to the level of understanding of the individual or typical participant signing the waiver.
• Not contain long, complex sentences or technical or legal jargon.
• Not mislead, misinform, or fail to inform participants of the waiver's benefits and limitations.
• Specifically mention, by name, every claim the employee is giving up.
• Not attempt to waive rights or claims arising after the waiver is signed.
• Provide something of value, beyond that to which the employee would have already been entitled (such as enhanced severance or any severance).
• Advise the employee to consult an attorney before signing.
• Give the employee 21 days to decide whether to sign the waiver. If the severance is connected to a termination program offered to a group of employees, that time period increases to 45 days (29 USC 1625).
If these conditions are not met, the agreement may not be enforceable. This means that the employee may still be able to bring a claim for age discrimination. In addition, employers must allow for a 7-day period after the waiver is signed during which the employee can revoke his or her decision (29 USC Sec. 626 (f)(1)). Employers should ensure that their waiver agreements and employment practices comply with the requirements of the OWBPA. Please see the national Age Discrimination section.
Must severance pay be returned if the agreement is invalid? The U.S. Supreme Court has ruled that a discharged employee does not have to return severance pay already received if the waiver signed did not comply with the OWBPA (Oubre v. Entergy Operations, Inc., 522 U.S. 422 (1998)).
Strict informational requirements. The EEOC requires that if the release is in connection with an exit incentive program or other termination program that applies to a group or class of employees, employers must provide all eligible participants with:
• The class, unit, or group of persons covered by the program; eligibility factors; and applicable time limits of the program;
• Job titles and ages of those individuals eligible for the program; and
• The ages of those individuals in the same “job classification or organizational unit” who are not eligible or were not selected for the program.
Employees may or may not be entitled to receive unemployment compensation at the same time they are receiving severance benefits. This is a state-specific area.
Please see the state Unemployment Compensation section.
As long as benefits are not required by state law, an employer may amend its severance policy or eliminate it altogether. Rights to severance benefits do not vest. The key is to make certain that the amendments to the severance policy or elimination of the policy are published and that all employees receive notice of the changes made.
Every business should have established guidelines concerning severance pay. Such a policy not only provides employees with guidelines, but also protects the employer from lawsuits based on claims of unfair business practices. Severance policies will vary according to an employer's needs. To institute a severance policy that is right for you, consider including sections that address:
Rationale. Briefly state the reason for granting severance pay.
Eligibility. Who is eligible to receive severance pay? Are only actively, regularly employed individuals eligible? Are employees covered by collective bargaining agreement or employees who have an individual written employment contract covered? Are employees who are terminated for gross misconduct eligible? What events qualify an individual for severance pay? Does discharge for poor job performance qualify an individual? Does layoff due to a reorganization qualify? Does termination due to elimination of a position? What if the person obtains another position within the company, a related company, or the company acquiring the business? As stated earlier, eligibility is usually limited to employees whose termination has been initiated by the company. Be sure to mention any other limitations regarding eligibility.
Payment schedule. If the amount of severance pay is linked to length of service, explain how it is determined. Is the amount of severance pay based on a base salary, a bonus, overtime, or other compensation? Will there be any amounts deducted from the severance pay?
Coordination with other benefits. Will the amount of severance pay be increased or decreased as a result of other benefits? For example, will someone who is on disability be eligible for severance pay? If disability pay ends because a job is eliminated, does the person then receive severance pay? Is severance pay reduced by any amount payable because of a competing state law?
Exceptions. If there are some groups of employees who receive different treatment or who will be handled on an individual basis (e.g. high level executives), say so.
Terminology. Keep in mind that a former employee's eligibility for unemployment benefits may be affected by the terminology used for “severance pay” or “pay in lieu of notice.” When using the term “severance pay,” unemployment offices may view the individual as being immediately eligible for unemployment benefits. In contrast, using the term “pay in lieu of notice” may qualify the individual for unemployment benefits until the end of the period for which the pay is intended.
When payment will be received. Will the employee receive his or her severance pay on the last day of work, or will it be mailed to his or her home at a later date? Will the pay be provided on a regularly scheduled payday? Will the payment be made over time (i.e., 3 months' severance pay paid over 6 months)? Keep in mind when deciding to pay severance that the cooperation of the employee may be needed for sometime after he or she leaves.
Maximums and minimums. Regardless of the formula for severance pay, it is a good idea to establish a maximum and a minimum for it. There may be exceptions to this where employers will want to pay more or less than those amounts. For example, an employer may want to increase severance pay beyond the normal rate if an employee asserts a discrimination claim against the company. In contrast, employers may not want to pay severance pay to an employee caught stealing.
Releases. As a condition for the payment of severance benefits, employers may require the individual to release them from any claims, such as violations of any discrimination law. Care should be taken to ensure that such a release is binding and enforceable.
Noncompete. Employers may wish to provide that an employee accepting severance pay cannot compete with them for a specific amount of time. This period may be linked to the amount of the severance pay or its duration.
Before committing the policy to writing, employers should also give careful consideration to:
The company's ability to pay. Is a large-scale payoff possible in the future? Would the company be able to pay each of the individuals who loses his or her job the promised severance pay? Many companies make the mistake of considering only individual separations when they draw up their policy on severance pay, and neglect to consider what it might cost the company in the unforeseen event that a large number of employees have to be terminated at the same time.
Relevant union contract provisions. If the company is unionized, severance pay may be a matter requiring negotiation. Review relevant portions of the contract before you write the policy.
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