The Seven Deadly Sins Of Severance Pay

Ice Miller

In these times of uncertainty, severance pay is an important human resource tool.  However, many employers and their advisors fail to recognize that severance pay policies pose unique, and often tricky, legal issues.  This article identifies the "seven deadly sins" that impact the design and administration of severance pay policies and will provide you with the tools to help you avoid committing them.

#1.       Failure to examine your severance pay policy to determine whether and to what extent Code section 409A may apply.

Section 409A was added to the Internal Revenue Code and became law on January 1, 2005.  Although the requirements of Section 409A are well beyond the scope of this article, Section 409A imposes strict limitations on:

        the timing of deferral elections,

        the ability to change elected forms of payment,

        the timing and manner of permitted payments,

        the funding of deferred compensation, and

        the discretion by the employer to change the form of payment. 

If a severance package fails to satisfy Section 409A, individuals may have to pay additional income tax on the amount of the deferral, interest, and a surtax equal to 20% of the amount included in income.  Although the statute imposes penalties on the employee, the Internal Revenue Service will likely seek to recover amounts from the employer (through the failure of the employer to report the income and withhold income taxes and the related penalties for non-compliance).

While Section 409A is commonly thought of as applying only to deferred compensation or nonqualified retirement plans, the IRS takes the position that severance pay policies can also apply. If you maintain a severance pay policy, or provide for severance in an employment agreement, regardless of whether it is an ERISA plan, Section 409A must be examined because it applies to many arrangements that traditionally may not have been thought of or treated as deferred compensation plans. 

According to the Internal Revenue Service issued Notice 2005-1, two types of severance pay arrangements are exempt from the requirements of Section 409A.

a. "Short-term deferrals" - where the payout occurs within 2 months after the end of the calendar year in which the benefit became "vested".  However, this exemption will not provide relief for many severance pay arrangements, because:

        they have payouts that extend beyond this 2 month period;

        the arrangements do not specifically state that payouts must be completed within this 2 month limit, and

        the policy states that the severance pay vests (i.e., it is payable after so many years of service or at retirement and the service or retirement condition is satisfied) even though payment is delayed until termination of employment or retirement.

b.  "Severance pay plans that qualify as welfare plans" under the Department of Labor Regulations (see discussion in #4 below), which are

        amended to comply with Code section 409A by the end of 2005, and

        either are collectively bargained or cover no employees that are "key employees" (a "key employee" is defined as an officer with annual compensation greater than $135,000) are not required to meet the requirements of Section 409A for 2005. 

This rule is for 2005 only. What will happen in 2006 and beyond is unclear.  As a result, you should examine all of your severance pay arrangements to determine whether and to what extent Code section 409A will impact them.

#2.       Failure to recognize that your severance pay policy is an ERISA plan.

Section 3(1)(B) of ERISA defines an employee benefit plan as, among other things, "any plan, fund, or program . . . established or maintained by an employer . . . for the purpose of providing for its participants or their beneficiaries . . . any benefit described in section 186(c) of this title."  Severance benefits are among those described in section 186(c).

Many employers, however, still fail to recognize that their severance pay policies or arrangements are "plans" subject to ERISA, even though it has been almost 20 years since the United States Supreme Court in Fort Halifax Packing Co., Inc. v. Coyne, 482 U.S. 1 (1987) established the standard for determining whether the payment of severance pay is pursuant to a "plan."  In Fort Halifax, the Supreme Court held that a one-time, lump sum severance payment triggered by a plant closing did not create an ERISA plan because it did not create the need for an "ongoing administrative scheme."  Accordingly, under Fort Halifax and the numerous cases that have followed it, the crucial questions that an employer must ask itself are:

        Is my severance pay arrangement more than just a one-time, lump sum payment to a group of employees triggered by a single event that is not anticipated to reoccur?

        Does my severance pay arrangement require an ongoing administrative scheme?

If the answer to either of these questions is "yes," your severance pay policy or arrangement probably is a plan subject to ERISA.

To determine what constitutes an "ongoing administrative scheme," courts have examined a number of factors: 

        the types of payments made under the arrangement (i.e., lump sum, periodic, alternative forms);

        the amount of company discretion in determining eligibility or benefits;

        the period of time over which benefits are paid;

        whether the arrangements are offered as a result of a single event or are generally available to employees from time to time;

        whether the terms of the severance arrangement are reasonably ascertainable to a reasonable person; and

        the need for monitoring, financial coordination or recordkeeping by the employer over a period of time. 

The further away an employer gets from a one-time, lump sum payment, the more likely a court or the Department of Labor will find that an ERISA plan exists.  In addition, arrangements have been found to constitute ERISA plans even where they were unwritten, or where they were described only in an informal policy statement given to supervisors or a video presentation.

#3.       Failure to recognize that individual severance agreements may create an ERISA plan.

In corporate transactions or reorganizations, companies commonly negotiate an individual severance agreement with a key employee.  Courts have long recognized that a group or pattern of similar severance agreements can constitute an ERISA plan.  Moreover, numerous courts have found that even an individual agreement for a single employee to receive severance benefits may be deemed an employee benefit plan subject to ERISA. 

If an individual severance agreement is subject to ERISA, it may be exempt from many of ERISA's requirements if the agreement qualifies as a "top hat plan."  Top hat plans are pension or welfare plans maintained by an employer primarily for a select group (which may be a group of one) of management or highly compensated employees.  To receive the top-hat plan exemption for a severance agreement that is a pension plan, an employer must timely file a top-hat statement with the Department of Labor.  A top-hat welfare plan, on the other hand, is exempt from all reporting and disclosure requirements, including the need to file a top-hat statement.  As a practical matter, an employer should file a top-hat statement for each of its new individual severance agreements if the agreement covers a highly compensated or key management employee.

#4.       Failure to determine whether a severance plan is a welfare plan or a pension plan.

Under ERISA, a severance plan can be either a pension plan or a welfare plan.  In spite of the fact that severance plans are similar to retirement plans in that benefits are not paid until after termination of employment, ERISA Section 3(2)(B) states that certain severance pay arrangements may be treated as welfare plans.  If the severance plan cannot qualify as a "top‑hat plan," treatment as a welfare plan is important because the burdens to most employers of complying with the ERISA funding, vesting and trust requirements for pension plans is not practical.

Under the Department of Labor regulations, a severance plan will be a welfare plan and not a pension plan if it meets all of the following criteria:

        Benefits are not contingent directly or indirectly upon the employee retiring.  (Benefits will be considered contingent on retiring if the eligibility criteria include age and/or service requirements that are indicative of retirement, such as age 55 and 10 years of service);

        The total amount of payments does not exceed 2 times the employee's annual compensation; and

        Except in the case of an employee whose service is terminated in connection with a "limited program of terminations" (as defined in the regulations), all payments to the employee are completed within 24 months after termination.

#5.       Failure to comply with ERISA if your severance pay arrangement is a plan.

If a severance arrangement is an ERISA welfare plan, then it must comply with the applicable requirements imposed by ERISA.  Those requirements are:

        All ERISA severance plans must file a Form 5500 annual report, unless the plan has fewer than 100 participants and any benefits which become payable are paid by an insurance company or out of the general assets of the employer.  The Department of Labor says that, for reporting purposes, an employer must count as a "participant" every employee who would be entitled to benefits if a qualifying termination occurred not just those for whom a qualifying termination has actually occurred.  For example, assume your severance pay policy states that all full-time employees will receive one week of severance pay for every year of service if their jobs are eliminated by a reduction in force.  You have 500 employees and, during 2005, you eliminate 50 of them due to a reduction in force.  For reporting purposes, your plan has 500 (not 50) participants, which means you would have to file a 5500 for 2005.

        All ERISA severance plans must be in writing and provide for detailed claims procedures as required by ERISA.

        All participants (see definition of "participant" above) in an ERISA severance plan must receive a summary plan description ("SPD") of the plan, explaining in plain English the key terms and conditions of the plan, unless the plan is an exempt top hat plan.  However, it is permissible for a single written document to serve as both the plan and SPD.  This avoids the possibility of inconsistencies between the plan and the SPD, but it requires that the single plan/SPD meet the readability and DOL content requirements for SPDs.

        All participants (see definition of "participant" above) in an ERISA severance plan must receive a summary annual report, unless the plan is exempt from filing a Form 5500 annual report.

If your severance arrangement is determined to be subject to ERISA and the requirements of ERISA have not been satisfied, your company, as well as the individuals who act as fiduciaries with respect to the severance arrangement, could be subject to various penalties.  These include: 

        criminal penalties for willful violations of ERISA's reporting and disclosure requirements (including possible imprisonment and fines of up to $500,000 for corporations);

        civil penalties for failing to provide required documents to participants upon request (up to $110 per day per violation);

        civil penalties for failure to file a Form 5500 annual report (up to $1,100 per day); and

        civil penalties for violations of Part 4 of Title I of ERISA (up to 20% of any so-called "applicable recovery amount").

Many employers comply with the Form 5500 reporting requirement by including the severance policy or plan as part of their overall so‑called "wrap‑around" employee welfare benefit plan and then file only a single Form 5500 each year.

#6.       Failure to take into consideration the advantages and disadvantages of ERISA when designing or negotiating your severance pay arrangements.

Although ERISA would impose certain reporting and disclosure requirements on your severance pay arrangements (and, if the arrangement is a pension plan that is not exempt as a top-hat plan, certain vesting, funding and trust requirements), there are several advantages to ERISA coverage to consider as you design and negotiate your severance pay arrangements. 

First, if your severance pay arrangement is subject to ERISA, ERISA would provide the exclusive remedy for any claims for severance pay under your plan because it preempts all state law claims relating to the plan, including, for example, claims for constructive discharge and punitive damages.  This could prove a definite advantage for you as, in many instances, state laws provide substantive remedies or requirements that are more onerous than those imposed by ERISA.  Moreover, no jury trial is available in actions to remedy ERISA violations which means a judge with ERISA knowledge will be deciding the claim.

In addition, ERISA's mandated detailed claims procedures are to your benefit, because claims procedures encourage the employer and the employee to resolve potential disputes without litigation.  ERISA case law is clear that a participant must exhaust his or her administrative remedies before filing a suit for benefits in state or federal court.

Finally, an employer has an opportunity to invoke protection for its claims decisions through its written plan documents.  If an employee's claim for severance benefits is denied and the employee files suit under ERISA, a court will favor the administrator's decision if the plan terms give the administrator full administrative discretion.  Therefore, as you design and draft your severance pay arrangements, it is extremely important that you include language that grants the administrator full discretionary authority to interpret and enforce all provisions of the program, and to decide who is eligible for benefits.  You should also include a statement that no benefit will be payable under the severance pay arrangement except as determined payable by the administrator in its sole discretion.

#7.       Failure to preserve your right to amend or terminate your severance pay arrangement.

Although lack of written plan terms may seem to allow employers greater latitude and discretion in paying severance packages, the absence of a written plan may actually restrict your ability to amend or terminate a severance package, particularly if the severance package is actually an ERISA plan (plus remember, if your severance pay arrangement is an ERISA plan, it must be in writing).  Numerous cases have found that where an employer handles its severance matters on an informal basis, the employer's past practices provide the basis on which a terminated employee or group of employees may make a claim for the same severance benefits.  This type of claim rests on the premise that the employer's past practices have established an ERISA plan, and that the benefit levels previously paid by the employer must be paid to the terminated employees now claiming benefits because the employer has not reserved the express right to reduce them.

In addition, a written plan allows the employer to determine what severance, if any, would be payable upon a specified event, such as a corporate sale, divestiture of a unit, restructuring, or a lay-off.  Having a plan document also allows an employer to grant the plan administrator the discretion to make all eligibility and benefit determinations, enabling the employer to have the benefit of deferential review of those determinations in the event of a lawsuit.  If the discretion to grant or deny severance pay is not expressly stated in a written plan, then you may be left with a court determining your severance pay benefits.

Conclusion

The design of a severance pay arrangement depends on an employer's objective.  Severance pay can serve many purposes, including acting as a recruiting tool, rewarding an employee for long service, or providing an employee with economic protection in the event of job elimination, downsizing or sale of the business.  Whatever the objective, employers and advisors must be mindful of the legal traps posed by severance pay arrangements.  By keeping in mind the "seven deadly sins" of severance pay when designing or negotiating your severance pay arrangements, you can achieve your desired objectives while avoiding unintended legal consequences.