Reasons to Offer Severance Benefits
Severance benefits are offered for many reasons:
- to provide a specific group of employees with continued income if they are terminated due to an event outside of their control (such as a reduction in force);
- to provide some protection to both current and prospective employees for a job loss;
- in exchange for a release of claims by a terminated employee;
- to maintain a competitive advantage with other companies for employee recruitment purposes; or
- to accommodate company culture and custom.
Types of Severance Benefits
Severance arrangements can be offered as the result of:
- an informal, customary practice of providing a terminated employee with cash or
- a formal plan providing a terminated employee with either a lump-sum payment or installment payments.
Generally, payments are calculated using a formula that applies on the occurrence of one or more predetermined events. Severance benefits are typically calculated based on the length of the employee’s service and rate of the employee’s pay. The class of employees eligible for severance benefits is also usually limited. For example, severance benefits can be provided based on the type of employment (e.g., full versus part time) or an employment location.
In addition to cash payments, severance benefits can include post-termination benefits, including:
- participation in other employee benefit plans (for example, life insurance plans);
- outplacement service; or
- life insurance coverage.
Informal Severance Arrangement
An informal severance arrangement is a customary practice not set out in a formal document. The practice can consist of providing terminated employees with severance benefits or a decision, made at the time of termination, to make a one-time payment to the terminated employee.
The advantages of an informal severance arrangement are that it:
- can provide flexibility for different severance benefits on an employee-by-employee basis because no expectations have been set;
- can be negotiated on an individual basis; and
- is adaptable for changes in the economy and for a range of other circumstances.
Generally, informal arrangements work better for small companies, companies with infrequent involuntary terminations, or companies that negotiate executive severance benefits on an individual basis.
The disadvantages of an informal severance arrangement are that it:
- can invite discrimination claims;
- does not work well in mass layoff situations because negotiating with each employee is time consuming; and
- can become an ERISA-governed plan, which may result in unanticipated legal consequences.
Formal Severance Arrangement
A formal severance arrangement consists of a written plan, policy, or arrangement that provides terminated employees with either a lump-sum payment or installment payments. Formal severance arrangements have significant, ongoing administrative requirements. These include an ongoing responsibility to budget for and make payments throughout the year and, for severance arrangements that terminate on a terminated employee’s commencement of employment with another employer, a responsibility to monitor whether terminated employees have obtained new employment.
The advantages of a formal severance arrangement are that it:
- can set expectations for employees if their jobs are eliminated or they are terminated for reasons beyond their control (and therefore serves as a morale and retention tool);
- provides consistency throughout the company;
- can provide protection for the company by using formal separation agreements or releases, or both;
- treats similarly situated employees equitably, which can help to shield the company from potential discrimination suits;
- can assist in recruiting because the company’s reputation may be elevated; and
- is easier to monitor compliance with all legal requirements.
The disadvantages of a formal severance arrangement are that it:
- is not as flexible as an informal arrangement;
- does not typically allow for individual negotiation; and
- requires more administration.
Severance Arrangements Subject to ERISA
The Employee Retirement Income Security Act of 1974 (ERISA), as amended, is a federal statute that governs employee benefit plans, including formal severance plans, policies, and funds, regardless of intent. A funded severance plan is automatically governed by ERISA. An unfunded, informal arrangement can be deemed to be covered by ERISA if it:
- provides employees with a series of payments and
- requires an ongoing administrative scheme.
Severance plans subject to ERISA must comply with certain requirements, including:
- reporting and disclosure requirements and
- claims and appeals requirements.
Severance plans subject to ERISA can be either welfare benefit or pension benefit plans. Generally, welfare benefit plans are preferable to pension benefit plans because welfare benefit plans are exempt from many of ERISA’s substantive requirements. Most severance arrangements are welfare benefit plans, but certain design features can cause the arrangement to be characterized as a pension benefit plan under ERISA. These features include the:
- amount of the severance benefits (generally, benefits that exceed twice the employee’s annual compensation for the year preceding the year in which the employee was terminated);
- payout period of the severance benefits (generally, benefits that are paid out for a period of more than twenty-four months); and
- conditions for receiving the severance benefits (generally, the payments are contingent on the employee retiring).
These features are provided according to the terms of the arrangement, if any, and do not cause a welfare benefit plan to become a pension benefit plan.
Conditioning Benefits on Waivers and Releases
Severance benefits may be conditioned on employees meeting certain terms, including nondisparagement provisions or releases or both. A release can minimize the risk of litigation by the employee following separation.
Taxation of Severance Benefits
Cash severance pay is taxable in the year the terminated employee receives it. The employer will include this amount on the employee’s Form W-2 and withhold appropriate federal and state income taxes, as well as employment taxes (such as Federal Insurance Contribution Act (FICA) taxes). The employer will provide the Form W-2 to the terminated employee by January 31 after the close of the calendar year of receipt.
The continuation of certain qualifying fringe benefits to a former employee may be excludable from the former employee’s income. For example, premiums paid by the employer for group term life insurance for the first $50,000 of coverage are excluded from the employee’s gross income. If the employer continues to provide taxable group term life insurance coverage (i.e., coverage in excess of $50,000) to a former employee, the taxable portion of the premiums will be subject to FICA taxes.
Employer-provided job placement assistance is generally excluded from gross income, but the assistance must be provided before the employee’s official termination date. If, however, outplacement services are provided in lieu of higher severance benefits, the services become taxable wages. Thus, the value of outplacement services may not be excluded from gross income if the employee has the option of electing to receive cash or another taxable benefit instead of outplacement services.
Internal Revenue Code § 409A
Section 409A of the Internal Revenue Code of 1986, as amended, sets out comprehensive rules for the taxation of nonqualified deferred compensation plans, including severance plans, unless they are exempt. Failure to comply results in adverse tax consequences for the employee. While most severance arrangements are exempt from § 409A, all severance arrangements must be carefully structured either to be exempt from § 409A or to comply with its regulations.
If the employer continues to pay a portion of a former employee’s health insurance premiums, these premium payments are excluded from the former employee’s gross income. Similarly, any insurance payments made for medical care of the former employee’s spouse or dependents also are excluded from gross income. The employer-paid insurance premiums are not subject to FICA taxes.
If the employer provides the health benefits by paying for all or a portion of a former employee’s COBRA healthcare continuation coverage, rather than under the employer’s health plan, below are several ways to process these payments.
- COBRA premiums may be paid to the employee, and the employee can then pay the insurance company directly. Because there is no guarantee that the employee will use the funds to pay the premiums, the funds are considered wages and subject to applicable taxes.
- An employer may reimburse premium payments the employee made directly to the insurance company. The employee must provide the employer with documentation verifying that payments to the insurer were made in order for the payments to be nontaxable and excluded from wages.
- An employer may pay the premiums directly to the insurance company. These funds are nontaxable to the employee and excluded from wages.
- An employer may provide funds for premiums under a severance plan. If the employer deducts the premiums from the severance pay and pays the insurer directly, the funds are excluded from wages and are nontaxable. If the employee receives the funds and can provide supporting documentation of the payment to the insurer, the funds are also nontaxable. If there is no verification that the employee used the funds to pay for the premiums, the amounts are included in wages and are taxable.
The premium subsidy is not included in the individual’s income. However, there is a phase-out of eligibility for the subsidy, which will increase some high-income individuals’ tax liability if they receive the subsidy. The phase-out impacts individuals whose modified adjusted gross income exceeds $125,000, or $250,000 for those filing joint returns. Tax liability is increased, to achieve repayment of a portion of the subsidy, for those taxpayers whose modified adjusted gross income is between $125,000 and $145,000, or $250,000 and $290,000 for those filing joint returns. If a taxpayer’s modified adjusted gross income exceeds $145,000, or $290,000 for those filing joint returns, the full amount of the subsidy must be repaid as an additional tax. There is no additional tax for individuals with a modified adjusted gross income less than these income levels.