Many employers maintain formal or informal severance policies or practices that they use sporadically. Other employers may implement a severance package for a limited period of time to reduce the number of employees overall or within a job classification or location. All employers should be aware that these policies, practices and programs may be subject to the requirements of the Employees Retirement Income Security Act 1974 (“ERISA”) and, without careful planning, to deferred compensation rules in force. under Section 409A of the Internal Revenue. Code (“Code”).
In general, a benefit policy or practice is considered a âplanâ submitted to ERISA if it provides one of the benefits identified in section 3 of ERISA and if a reasonable person can verify (i) the existence of planned benefits and beneficiaries, (ii) the source of funding, and (iii) a procedure for collecting benefits. An employer’s practice of providing severance benefits to individual employees may not be a severance plan submitted to ERISA if the benefits are paid on an ad hoc basis and there is no such benefit. has no defined procedure for paying them. In its decision Fort Halifax Packing Co. v. Coyne, the United States Supreme Court determined that an ERISA severance plan must have a permanent administrative scheme and ruled that a single severance pay triggered by a single event is not an ERISA plan. On the other hand, if the employer has specific procedures in place (for example, the policy identifies who is eligible for benefits and contains a benefit formula), and there is an ongoing administrative program, or if the employer enters into a number of identical or very similar contracts, the employer’s severance pay policy will be treated as a severance pay plan submitted to ERISA.
Safe Harbor Rule for Termination Plans
Under ERISA, a plan, fund or program that (i) provides retirement income to employees or (ii) results in a deferral of income by employees for a period of up to or beyond termination of employment is generally treated as a pension plan subject to complex rules of participation, benefits, vesting and funding. A plan, fund or program established by an employer for the purpose of providing unemployment benefits or the benefits described in Section 302 (c) of the Labor Relations Act 1947 (which lists benefits departure) is treated as an employee welfare plan under ERISA and is exempt from the more stringent pension plan requirements.
The Department of Labor has created a safe harbor rule for severance pay plans under which an arrangement providing for the payment of severance pay on termination will be treated as a severance pay plan and not like a pension plan, provided that:
- the payments are not contingent, directly or indirectly, on the employee’s retirement;
- the total amount of the payments does not exceed the equivalent of double the annual remuneration of the employee during the year immediately preceding the termination of employment; and
- all payments to the employee are made (i) in the case of an employee whose service is terminated under a limited termination program, no later than 24 months after the termination of employment of employee or 24 months after the employee has reached normal retirement age, or (ii) in the case of any other employee, within 24 months of the employee’s termination of employment.
For this purpose, “annual remuneration” is defined as the total of all remuneration, including wages, salaries and any other benefit of monetary value, whether paid in cash or otherwise, which has been paid in consideration for services rendered by the employee to the employer during the year (or that would have been paid at the employee’s usual rate of pay had the employee worked a full year).
A severance pay policy can be treated as an ERISA plan even if the policy is unwritten. For example, if an employer has established a practice of providing employees who are involuntarily terminated with one week’s pay for each year of service, then the practice will be treated as a scheme subject to ERISA. In this case, the plan must meet the requirements of the ERISA plan, including:
- The requirement for a formal plan document;
- Participant disclosure requirements, which may include the distribution of a summary description of the plan, summaries of material changes and / or summary annual reports;
- Reporting requirements, which may include filing annual returns (Form 5500); and
- ERISA fiduciary requirements. 
An employer who sponsors an ERISA-covered severance plan but does not comply with ERISA requirements may be subject to taxes and penalties (for example, up to $ 2,259 per day for failing to file the annual report).
Benefits of an ERISA severance plan
Employers may have additional responsibilities when maintaining an ERISA severance package, but there are benefits. If ERISA applies to a severance plan, claims made by a participant under state and common law (such as breach of contract, salary laws of the (State or Promissory Estoppel) are generally pre-empted and the participant’s only remedies fall under ERISA. Many state laws provide for punitive damages in claims relating to an employee’s employment and benefits. ERISA does not provide for punitive damages and the courts have been reluctant to incorporate this type of award into law. Additionally, an employer can usually withdraw a lawsuit brought in state court to federal court. Finally, if an indemnity plan (and / or its summary description of the plan) contains the appropriate language, the decisions of the plan trustee may be subject to deference by a court and will only be overturned by a federal court. whether the plan trustee acted in an arbitrary and capricious manner. in the interpretation of the plan or in the denial of benefits.
Considerations for Section 409A of the Code
In general, if an employee has a legally binding right in one year to receive payment of an allowance in another year, there will be a deferral of the allowance and the payment may be subject to section 409A of the Coded. In addition, a plan that provides severance benefits may be treated as a deferred compensation plan under section 409A if the severance benefits are paid over more than one year. Unless the employer puts in place a formal deferred compensation plan that specifies when and form of payment and subjects deferred compensation payments to substantial risk of forfeiture, deferred compensation will be taxed in the year it exists. a legally binding right to receive it, regardless of when it is actually paid. Under these rules, severance pay paid over more than one year can be included in an employee’s gross income in the year in which the employee terminates employment.
Safe Harbor Rule for Termination Plans
Some bona fide termination agreements that provide for severance pay based on a involuntary termination of employment or by virtue of a window program are excluded from article 409A of the Code. A voluntary departure plan will not be exempt from Section 409A unless it is offered as part of a window program. A window program exists if severance pay is offered to employees who terminate their employment within a limited period (not to exceed 12 months) under specified circumstances. A severance package agreement will not be treated as a window program if the employer establishes a tendency to pay similar severance packages in similar situations over substantially consecutive periods.
In order to be exempt from the deferred remuneration rules of article 409A of the Code, the termination agreement must not exceed twice the lesser of: (i) the employee’s annualized compensation based on the annual rate of pay for services provided to the employer for the tax year preceding the separation, or (ii) the annual compensation limit under the Article 401 (a) (17) of the Code for a pension plan ($ 290,000 for 2021). In addition, payments must be made no later than two years after the calendar year in which the employee ended. This Safe Harbor rule is not the same as, but is consistent with, the Safe Harbor for severance plans under ERISA.
In addition, other post-termination benefits provided under a severance package may be exempt from section 409A, including:
- Reimbursements that may be excluded from the employee’s income, such as business reimbursements and moving expenses;
- Reimbursement of medical expenses during the period during which the former employee could have chosen COBRA continuous coverage; and
- Certain payments in kind and payments for goods and services.
Unless post-termination benefits are excluded from employee income under the Code, benefits will be exempt from section 409A only if the post-termination benefits, as a whole, do not exceed the dollar amount under Section 402 (g) of the Code (1) b) for the year of separation (which is $ 19,500 for 2021).
Short-term deferral exception
If an employer wishes to pay severance pay that exceeds the amounts allowed under the Safe Harbor rule for severance pay plans, the payments can still be exempt from section 409A of the Code under the short-term deferral exception. In general, severance pay paid to an employee who terminates employment, voluntarily or involuntarily, will not be treated as deferred benefits subject to section 409A if all payments are made within 2.5 months of termination. end of the year in which the employee’s termination occurs.
This article provides a high-level summary of ERISA and the tax issues that must be addressed when an employer seeks to implement a temporary or permanent termination benefits program. Other issues may include the need to comply with the Age Discrimination in Employment Act (“ADEA”) and obtain ADEA waivers for older employees, and the impact severance pay on other social benefits. Tax-exempt employers and some government employers must structure severance pay plans to comply with section 457 of the Code. An employer should consult with legal counsel before implementing a severance package.
 There is an exemption from most of these requirements for so-called âtop hatâ plans which are maintained only for highly paid or selected executive employees. However, other employees cannot participate in a top hat plan.