Three Questions to Ask When Designing a Severance Package

Date: January 19, 2018

Originally published by ASAE.

Don't let your association's severance policy lead you into legal trouble. Consider these three important questions when designing a pay and benefits package for outgoing employees.

Severance plans can be viewed as a necessary evil in some industries or a generous gesture and benefit for other employees whose employment is terminated involuntarily.

However, many employers make the mistake of simply setting forth severance plan terms in an employee handbook, a practice that can lead to legal pitfalls for the employer and, in some cases, the departing employee. A better approach is to carefully design a severance program and properly draft employee agreements, bearing in mind how different types of programs are classified and construed under the law. 

When designing and administering a severance program, keep three essential questions in mind. 

What Does ERISA Require?

The Employee Retirement Income Security Act of 1974 governs plans that provide pension and welfare benefits to employees. A severance program is subject to ERISA requirements if it is an “administrative scheme” that is carried out following a triggering event, such as a reduction in force. For example, a severance program providing for one week's pay for each year of service for employees who are let go in a reduction in force is an administrative scheme. 

Contrast this with an ad hoc program whereby an employer provides severance benefits only occasionally and usually in conjunction with a negotiated employee departure. You might say, “Sorry, we had to let you go, but we'll give you some money, and you give us a release.” This is viewed as a payroll practice, rather than an administrative scheme subject to ERISA. 

Here is where the employee handbook comes in. If the policy is described in the handbook, chances are good that it will be construed as an administrative scheme, meaning that the severance program is a plan subject to ERISA. In that case, the employer will have to meet several requirements: It must maintain a plan document describing, among other items, eligibility for participation and the procedures for amending and terminating the plan, and it must distribute a summary plan description to eligible participants. The summary plan description is required to be distributed upon an employee's initial eligibility for participation and periodically thereafter following amendments or every ten years.

An eligible employee may request copies of these documents. After receiving a written request for the documents, employers have 30 days to deliver or be subject to fines, absent a showing of good cause for not providing the documents. Never having adopted a plan or prepared a summary plan description is not good cause.

Is It a Pension Plan?

A severance plan or a negotiated benefit with a single employee should be structured to avoid classification as a pension plan rather than a welfare plan. Pension plans are subject to myriad rules, including nondiscrimination, funding, vesting, and Pension Benefit Guaranty Corporation coverage and premiums in many circumstances. 

If payment of severance benefits is conditioned on an employee's retirement, the arrangement may be found to be a pension plan. Payment may be found to be conditioned on retirement if, for example, the severance benefit is available only to participants who are at or near retirement age. In addition, the financial terms of the agreement must meet certain limitations to avoid classification as a pension plan: The total payments cannot exceed more than twice the employee's annual pay during the year before the termination, and payments cannot be made for longer than 24 months after the employee's departure.

Is It a Nonqualified Deferred Compensation Plan? 

It is also important to ensure that a severance plan is not a nonqualified deferred compensation plan (NQDC) in disguise. Avoiding this classification is particularly important for tax-exempt entities. Under the Internal Revenue Code, an employee's entitlement to future payments from the employer is viewed as a deferred compensation plan, unless an exception applies. 

One of these exceptions is for bona fide severance arrangements, which provide payment to an employee after an involuntary termination. The total payments cannot exceed two times the employee's annualized pay for the year preceding the termination or two times the dollar limit on retirement pay ($270,000 for 2017), whichever is less. In addition, payment must generally be concluded by the last day of the calendar year that is two years following the date of termination. 

Classification of a severance arrangement as a NQDC plan has harmful consequences for the departing employee and the sponsoring organization. In such a case, he or she would be subject to income tax for the entire amount of the future payments in the tax year of termination because of the “taxed when vested” rule that applies to tax-exempt organizations. Likewise, the organization would have tax reporting obligations in the year of the employee's termination. 

The organization's staff is responsible for design, drafting, and developing oversight of the severance plan. Typically that effort would include human resources, finance, and legal counsel. As with all personnel policies, the severance program should be reviewed on a periodic basis to confirm that the program continues to meet the needs of the organization and is in line with industry standards.

Don't let your association's generosity to employees morph into legal problems—for you or for them. Careful design of the program and your employment agreements can prevent a host of issues.