Employers considering a reduction of their workforce during this economic downturn should review their severance pay practices to ensure that they comply with ERISA and/or section 409A of the Internal Revenue Code (“Code”), if applicable.
Your severance pay practice may be subject to ERISA if it meets the definition of an “employee benefit plan.” An employee benefit plan can be either a welfare benefit plan or a pension benefit plan. An “employee welfare benefit plan” under ERISA is “any plan, fund or program…established or maintained for the purpose of providing for its participants... benefits in the event of…unemployment…or any benefit described in Section 302(c) of the Labor Management Relations Act, 1947.” ERISA Section 3(1). In contrast, a “pension benefit plan” under ERISA is “a plan, fund, or program which…provides retirement income to employees or results in deferral of income…extending to the termination of covered employment or beyond….”
A severance pay practice constitutes a “plan, fund, or program” under ERISA where it requires the employer to establish either (1) an administrative system to meet the employer's obligation to pay severance benefits or (2) an ongoing administrative responsibility to determine eligibility and benefits. See Fort Halifax Packing Co., Inc. v. Coyne, 482 U.S. 1 (1987). The U.S. Supreme Court reasoned that a one-time, lump-sum payment that is triggered by a single event is not a severance plan subject to ERISA because it requires neither an administrative scheme nor the need for financial coordination or control (i.e., the employer does not face any on-going demands on its assets).
In determining whether an employer’s severance pay practice is subject to ERISA, courts have tended to focus on the following factors: (1) whether the program requires the employer’s managerial discretion in its administration, (2) whether a reasonable employee would perceive an ongoing commitment by the employer to provide employee benefits, (3) whether the employer is required to analyze the circumstances of each employee’s termination separately in light of certain criteria, and (4) whether the delivery of benefits creates an ongoing demand on employer assets.
If your severance pay plan qualifies as an ERISA welfare benefit plan, it is subject to ERISA’s reporting and fiduciary requirements. If your severance pay plan is an ERISA pension benefit plan, in addition to the reporting and fiduciary requirements, your plan must comply with ERISA’s more burdensome requirements pertaining to disclosure, funding, eligibility, vesting, participation, and administration.
Code Section 409A Considerations
Section 409A applies to any plan or other arrangement that provides for the deferral of compensation. A plan or arrangement provides for the deferral of compensation to the extent it creates a legally binding right to have compensation earned in one taxable year paid in a future taxable year. Plans subject to section 409A must meet stringent requirements, as addressed later in this article, and if they fail to do so, the employees are required to pay an additional 20% tax on the deferred compensation, plus interest.
Fortunately, the Code recognizes two ways for severance pay plans to avoid the reach of section 409A. First, section 409A does not apply to “bona fide severance pay plans” because such plans are not considered deferred compensation plans under section 409A. Unfortunately, neither the Code nor relevant Treasury Regulations define the term “bona fide severance plan.” Likewise, the Internal Revenue Service (“Service”) has not issued formal guidance on the meaning of this term. Nevertheless, in informal advice, the Service indicates that “severance pay” connotes payments made to an employee arising from the termination of employment under unanticipated circumstances while “deferred compensation” provides for payments because of the termination of employment. In our view, this provides very little insight for employers trying to determine whether they have a bona fide severance pay plan that is not subject to Code section 409A or a deferred compensation plan that is subject to that section.
Second, even if your severance pay plan does not qualify as a bona fide severance plan, the plan will not be subject to section 409A if it meets the “separation pay” exception. To meet this exception, the plan must provide for separation pay only upon either: (1) involuntary separation from service or (2) separation during a limited period of time or under certain circumstances (a “window program”). If your plan is not a collectively-bargained separation pay plan, the separation pay also must: (a) not exceed twice the lesser of the employee’s compensation or the section 401(a)(17) compensation limit ($245,000 in 2009); and (b) be paid out over two years or less. A severance pay plan can also provide for reimbursement of expenses, payment of medical benefits or certain other limited payments upon separation from service.
These payments are not considered to defer compensation provided they are limited in amount and are offered for a limited period of time, as specified in Code section 409A.
If your severance pay plan is neither a bona fide severance pay plan nor a plan for separation pay under the Code, then your plan is subject to section 409A. As such, you must draft your plan to comply with section 409A’s numerous requirements to avoid the imposition of additional taxes. The severance plan must: (1) be in writing; (2) provide that payment of benefits be limited to one of six permissible payment events; (3) provide that the amount and time and form of payment is fixed and irrevocable at the earliest time that a participant has a legally binding right to the compensation; (4) provide that subsequent changes in time and form of payment be made only under certain conditions; (5) provide that acceleration of the time or form of payment is permitted only under limited circumstances; and (6) not segregate plan assets, if any, in offshore trusts.
As the likelihood of employee terminations increases in this difficult economy, employers should review their severance pay plans to determine if they are subject to ERISA and/or section 409A of the Internal Revenue Code and if so, to ensure that their plans are legally compliant. Given the complex nature of these matters, employers are often wise to involve legal counsel in this process.