September 14, 2009
The current economic climate has caused many employers to institute reductions in force. In doing so, employers often provide their former employees with severance pay in an effort to soften the impact of unemployment. Normally, both the employer and the employee recipient incur taxes imposed by the Federal Insurance Contributions Act ("FICA")1 on these payments. However, it is possible for both employers and employees to reduce FICA taxes by structuring some or all of these severance payments as supplemental unemployment benefit payments ("SUB-Pay").
CSX case overturned on appeal
In a previous Cooley Alert we discussed the 2002 Court of Federal Claims decision in CSX Corporation, Inc. v. U.S., 52 Fed.Cl. 208 (Apr. 1, 2002), in which the court held that severance paid in connection with involuntary separation from employment was not subject to FICA taxes so long as the payments qualified as "supplemental unemployment compensation" as defined in Section 3402(o) of the Internal Revenue Code of 1986, as amended (the "Code"). That holding was overturned on appeal.
On appeal, the United States Court of Appeals for the Federal Circuit held in CSX Corporation, Inc. v. U.S., 518 F.3d 1328 (Mar. 6, 2008) that only certain types of severance pay are exempt from FICA as SUB-Pay. The court clarified that Section 3402(o) of the Code defines "supplemental unemployment compensation" for the purpose of treating such compensation as wages for purposes of income tax withholding, but not for exempting such compensation from the definition of "wages" for purposes of FICA taxes. Instead, the court held that SUB-Pay is defined by a series of Internal Revenue Service ("IRS") administrative pronouncements and that severance pay will be considered SUB-Pay exempt from FICA only if such pay is intended to supplement state unemployment benefits and is structured in accordance with Revenue Rulings 56-249 and 90-72 (the "Revenue Rulings").2
Severance pay that qualifies as exempt SUB-Pay
Employers wishing to establish severance pay as a form of SUB-Pay should ensure that such payments are administered under a plan with SUB-Pay provisions that are similar in all material respects to the plans described in the Revenue Rulings. While these Revenue Rulings leave room for plan flexibility, the fundamental design and purpose of the plan must be to supplement state unemployment benefits, which typically means including the following features:
- Benefits are available only to unemployed former employees who were involuntarily terminated by the employer for non-performance reasons
- Benefits may not be paid to individuals ineligible for state unemployment benefits, except in limited circumstances3
- Benefits must be paid in periodic amounts that correspond to periodic state unemployment benefit payments and not in a lump sum
- Individuals have no right to benefits until they satisfy the conditions for eligibility to receive benefits following termination of employment
- The amount of the benefit, when combined with any other remuneration paid by the employer in connection with the termination, may not disqualify the individual from receiving state unemployment benefits
- Benefits are not attributable to an individual rendering particular services during the period of unemployment4
- The plan under which the benefits are paid may, but need not, accumulate funds in a trust account5
Because severance pay that is intended to be SUB-Pay must supplement state unemployment compensation, a company should review the unemployment compensation program of each state in which its employees work. In California, for example, individuals receiving state benefits must have lost their job through no fault of their own and be physically able to work, available to work and actively looking for work. The California benefit is paid weekly up to a maximum amount of $450 per week for no more than 79 weeks,6 based on the employee's compensation prior to termination. In most states (including California), SUB-Pay will not disqualify a former employee from receiving state unemployment compensation, thereby making it feasible to structure severance pay as SUB-Pay in coordination with state unemployment compensation.7
Tax benefits of a properly structured SUB-Pay plan
The tables below provide estimates of the FICA tax savings that an employer could realize through a properly structured SUB-Pay plan; they do not reflect the employee FICA savings, the employer FUTA tax savings, net savings from reducing severance payments by the amount of state unemployment compensation, or savings from discontinuing payments due to reemployment. The tables assume that the employer pays severance intended as SUB-Pay throughout the designated time periods in an amount based on the employees' salaries prior to termination.8
FICA tax savings from a property structured SUB-Pay plan
|# of Employees||2 Months||4 Months||6 Months|
|$50,000 Average Annual Salary|
|$75,000 Average Annual Salary|
In designing and adopting a plan providing severance pay that is intended to qualify as exempt SUB-Pay, employers should focus on the following:
Coordination with and enhancement of severance plans. Employers that currently maintain severance plans can amend their existing plans or adopt new plans to provide for the possibility of paying "traditional severance"10 to certain former employees as well as exempt SUB-Pay to other individuals not eligible for such traditional severance pay. For example, an employer could establish two severance pay plans, one providing traditional severance pay to executive employees and the other providing exempt SUB-Pay to non-executive employees, or could achieve the same result using a single plan covering both groups of employees.11
Determine duration and amount of benefit. Employers may structure severance pay that is intended to be SUB-Pay in accordance with the Revenue Rulings while still maintaining some flexibility with regard to the amount and timing of the payments. For example, SUB-Pay may extend beyond the maximum duration of the state unemployment benefit if the recipient otherwise maintains eligibility for such state unemployment benefit. The amount of each payment must be tied to the state benefit, but the Revenue Rulings do not mandate a specific formula, so employers can tailor the benefit formula to their particular goals in providing severance pay. For example, SUB-Pay might be expressed as a multiple of the state benefit or a percentage of the employee's former salary, or may be based in part on an employee's seniority or years of service. In addition, employers may choose to reduce the amount of SUB-Pay by the amount of state unemployment compensation to factor in administrative costs.12
Avoiding employee windfall. Providing exempt SUB-Pay prevents former employees from receiving a windfall if they become reemployed before the maximum period of promised payment ends. Because SUB-Pay is tied to eligibility for state unemployment, unlike many traditional severance plans, such payments must cease upon an employee's becoming ineligible for state unemployment benefits (e.g., upon the employee's reemployment). To this extent, periodic SUB-Pay is preferable and can provide significant savings to the employer.
Employers cannot reduce FICA taxes on severance pay simply by ensuring that payments fall within the definition of "supplemental unemployment compensation" contained in Section 3402(o) of the Code.
Severance payments will be exempt from FICA taxes if they are structured to supplement state unemployment compensation in accordance with Revenue Rulings 56-249 and 90-72.
Employers can amend their current severance plans or adopt new plans to achieve significant FICA tax savings and avoid payment of severance benefits during periods of subsequent re-employment.
If you have questions about this Alert, please contact one of the attorneys listed above.
Circular 230 Disclosure
The following disclosure is provided in accordance with the Internal Revenue Service's Circular 230 (21 CFR Part 10). Any tax advice contained in this Alert is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person.
1 In 2009, the FICA tax rate is 7.65% (15.3% combined employee and employer rate), which includes a 6.2% Social Security tax on the first $106,800 of wages and a 1.45% Medicare tax. Additionally, employers are subject to a 6.2% tax rate under the Federal Unemployment Tax Act ("FUTA") on the first $7,000 paid to each employee as wages. All references in this Alert to severance payments that may be structured to be exempt from FICA taxes are intended to encompass exemption from FUTA taxes as well.
2 See Rev. Rul. 56-249, 1956-1 C.B. 488 and Rev. Rul. 90-72, 1990-2 C.B. 211.
3 Revenue Ruling 56-249 specifies that severance pay to a former employee who is ineligible for state unemployment benefits may nonetheless qualify as SUB-Pay if the employee is otherwise eligible but for one of the following circumstances: (1) the employee has insufficient wage credits under state law, (2) the employee has exhausted the duration of benefits under state law or (3) the employee has not met a waiting period required under state law. Additionally, the IRS permits a 1% or "de minimis" amount of total plan benefits to be paid that are not tied to state unemployment benefits (for example, payments to full-time students or individuals receiving medical disability payments).
4 For example, benefits may not be contingent on a former employee providing post-termination consulting services to the former employer.
5 If a trust is utilized, these trusts typically are qualified as exempt from federal income tax under Section 501(a) of the Code as a SUB trust described in Section 501(c)(17) of the Code.
6 California generally pays 26 weeks of unemployment benefits, but individuals may be eligible for up to 53 additional weeks under current federal and state extensions and the Federal American Recovery and Reinvestment Act. According to a June 2009 Wall Street Journal survey of all state unemployment benefits, the duration of state benefits ranges from 46 – 79 weeks in amounts from $230 to $940 per week.
7 According to the Department of Labor 2008 Comparison of State Unemployment Insurance Laws, 48 states (including California) permit SUB-Pay to supplement unemployment compensation without affecting the individual's eligibility for the state unemployment benefit.
8 Note that the tables assume that employees' wages have not yet exceeded the "taxable wage base" ($106,800 for 2009) applicable to the Social Security portion of FICA. Smaller savings would be realized with respect to wages in excess of the taxable wage base.
9 $50,000/12 = $4,167 severance pay per month. $4,167 x 2 months = $8,333.33 severance pay per employee. $8,333.33 x 7.65% FICA tax rate = $637.50 employer FICA tax savings per employee. The same formula is applied throughout.
10 Typically, severance pay that is not tied to a period of actual unemployment but rather is paid in a lump sum or for a specified number of weeks in a specified amount that is tied to previous compensation and possibly position within the company and length of service.
11 According to IRS Private Letter Ruling 9523023, treatment of some payments under a severance plan to some individuals as wages for FICA and FUTA purposes does not disqualify other payments under the plan to different individuals from treatment as SUB-Pay. Additionally, it may be possible to structure a plan that includes a "limited exemption" for a "small number of recipients" to provide for continued traditional severance pay as a replacement for SUB-Pay in the event an individual no longer qualifies for SUB-Pay (e.g., individual obtains subsequent employment) without disqualifying other payments under the plan to different individuals from treatment as SUB-Pay. See IRS Private Letter Ruling 200709056.
12 Additional administrative costs involved in providing SUB-Pay include the cost of verifying employees' eligibility for state unemployment benefits and monitoring continued actual payment of such benefits on a periodic basis.