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Severance Benefits: What Employers Should Know

In the United States, it is common for employers to offer severance benefits to their employees. Severance benefits often take the form of a cash payment to employees that are involuntarily terminated.

Many legal disputes can arise in connection with the implementation and administration of severance plans. It is therefore important for a company’s in-house legal team to have an understanding of the key features of severance arrangements.

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Types of Arrangements

Employers have flexibility in how they structure their severance policies. Some employers adopt relatively formal severance benefits that involve ongoing administrative requirements. On the other hand, some employers will have more informal severance programs in place, providing terminated employees with a small cash payment.

Formal severance arrangements usually are structured to provide terminated employees with either a lump-sum payment or a series of installments. The amount of the payments is generally tied to the terminated employee’s length of service and salary. A set formula is usually applied to calculate the amount.

ERISA

Some severance plans are subject to comply with the requirements promulgated by the Employee Retirement Income Security Act of 1974 (ERISA). In structuring severance arrangements, employers should take into consideration whether the arrangement will cause the severance plan to be subject to ERISA requirements.

ERISA requirements often apply to severance benefits that are pursuant to a plan, fund, or program. A severance arrangement is likely to be deemed a plan that falls under ERISA’s mandates if it:

  • A group of employees is provided a series of payments, rather than a lump-sum payment, upon the occurrence of a one-time event
  • It requires an ongoing administrative scheme

However, courts have also found unfunded severance arrangements to be subject to ERISA requirements.

Severance plans governed by ERISA have to comply with a number of ongoing reporting requirements, including the filing of a Form 5500 and the distribution of a compliant summary plan description. The violation of ERISA requirements can result in substantial penalties.

Administration of Severance Plans

Employers should be aware of the common pitfalls that can arise in implementing and administering a severance policy. These include:

  • Discrimination complaints
  • Noncompliance with ERISA requirements
  • Severance benefits conditioned on non-disparagement provisions and releases
  • Informally established severance plans

Age discrimination complaints are a commonly encountered issue for employers in administering severance benefits. Discriminating between older and younger workers in paying severance benefits can violate the Age Discrimination in Employment Act of 1967 (ADEA).

One common scenario can arise when employers deny severance benefits to employees who are eligible for retirement while paying severance benefits to younger employees who are not retirement eligible.

Severance plans that are not formally documented can run into problems. It is a best practice for companies that are implementing severance benefits to adopt a formal severance plan. The written plan should provide clear guidance on the treatment of similarly situated workers and the means for calculating the payment amount.

Amending and Terminating Severance Plans

Employers may have some flexibility to amend or eliminate severance benefits. This depends on whether the severance plan includes specific language that allows the employer to modify the plan document. The ERISA rules do not provide a guarantee of vested rights under welfare plans, which include severance plans that are treated as welfare plans. Therefore, it is possible for an employer to amend or terminate a severance plan under certain circumstances without violating ERISA.

Severance Plans and Section 409A

Under Section 409A of the Internal Revenue Service (IRS) regulations, severance benefits are exempt from coverage if certain conditions are met. However, many nonqualified deferred compensation plans, including severance plans, are subject to Section 409A tax rules.

The failure to comply with Section 409A has consequences for the employee, not the employer. These consequences include full taxation of all deferred compensation of the same type and a 20% penalty tax.

Severance Plans and FICA

The Federal Insurance Contributions Act (FICA) classifies certain payments to employees as taxable wages. In the legal case United States v. Quality Stores, the U.S. Supreme Court held that severance payments to Quality Store employees that were involuntarily terminated due to plan shutdowns were considered taxable wages.

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