United States: Is My Severance Plan Subject To ERISA Or Section 409A?

Recent volatility in the job market has caused many employers to implement reductions in force and employee lay-off programs. In order to reduce the economic consequences of an unanticipated job loss and mitigate the negative employee relations issues that can result from downsizing, many employers will offer those employees who are involuntarily dismissed a severance package or separation pay.

The primary benefit of severance pay is that the terminated employee receives a portion of their salary for a specified period of time. A common severance pay amount is two weeks of compensation. For executives, it is common to pay the executive one month of salary for each year the employee has worked for the company. In some cases, such as with senior level executives, the severance pay can exceed what the employee would have received in salary had they remained at the company.

Many severance arrangements are not formalized and simply consist of continuation pay for a specified period of time following termination of employment. Some employers prepare written policies or even adopt a formal severance plan with specific rules for participation and benefits. In both instances, employers should be aware of the various compliance issues that may have been overlooked and to avoid costly and unforeseen penalties if the severance arrangement is covered by the Employee Retirement Income Security Act ("ERISA") or Internal Revenue Code Section 409A.

ERISA and Severance Plans

A formal, or informal, severance plan may be governed by ERISA. While most employers are aware of ERISA's application to retirement plans and group health plans, many are surprised to learn that some severance arrangements are considered "welfare plans" under ERISA and, are therefore, subject to ERISA's reporting and disclosure requirements, as well as the rules for processing and determining claims. If the severance plan is subject to Section 3(1) of ERISA,¹ it will likely be required, among other things, to prepare and submit a completed Form 5500, make available a compliant Summary Plan Description to participants; and establish proper procedures for participants to appeal adverse claim determinations.

Because not every severance arrangement is covered by ERISA, many employers overlook its potential application when they are implementing or designing a severance plan. Although the application of ERISA is not a bad thing for employers, it can become a compliance concern if the employer is not aware of the various requirements that must be met if a severance plan is subject to ERISA.

How do Severance Plans Comply With ERISA?

Welfare plans are subject to significantly fewer ERISA requirements than pension plans, which makes compliance much easier to accomplish. Generally, for a severance plan to be an ERISA welfare plan, the following requirements must be met:

• The severance plan payment may not be contingent upon the employee retiring;
• The total amount of the payments to be made may not exceed two times the employee's annual compensation during the last full year of employment; and
• All payments must be made within 24 months following the employee's termination.

If the severance policy is an ERISA welfare plan, it must be drafted and administered to comply with ERISA's reporting and disclosure requirements (among other requirements), including but not limited to:

• Drafting a formal detailed plan with claims and appeals procedures;
• Filing the plan with the Department of Labor;
• Distributing that plan and any plan communications to the participants;
• Filing the plan's annual Form 5500 (the annual tax reporting form) with the Internal Revenue Service ("IRS") and Department of Labor;
• Distributing and filing annual summary reports to participants and the Department of Labor; and
• Notifying participants of plan changes and providing plan-related documents to participants upon request.

Does ERISA Apply to My Severance Plan?

The U.S. Supreme Court set the standard for determining whether the payment of severance pay is a "plan" under ERISA, in the case Fort Halifax Packing Co., Inc. v. Coyne. ² At issue in Fort Halifax was whether a Maine statute that required employers to provide their employees with a one-time severance payment upon a plant closure established an ERISA plan. The Supreme Court held that in order for an arrangement to be subject to ERISA, the administration of the arrangement must generally include the two components discussed below to be an ERISA plan.

An Ongoing Administrative Program

The Court found (in a narrow 5-4 decision) that the employer's approach was not subject to ERISA because it simply required a one-time obligation of the employer, with no need for an ongoing administrative program for processing claims and paying benefits. The Court's majority opinion made clear that "[s]ome severance benefit obligations by their nature necessitate an ongoing administrative scheme, but others do not. Those that do not, such as the obligation imposed in this case, simply [are not subject to ERISA.]"

Clear Eligibility Standards or Benefit Provisions

An ERISA plan must also generally have sufficient detail to enable individuals to determine the available benefits. In other words, a severance program that has an ongoing administrative program may nonetheless still not be an ERISA plan if it is not clear who is eligible and for what benefit amount.

The less discretion and administration required to implement the plan the greater the likelihood that the severance plan is really a payroll practice and, therefore, not subject to ERISA. Therefore, if the plan is implemented just once for a single occasion, it is unlikely that a court will find that ERISA applies.

What are the Benefits of an ERISA Severance Plan?

Like any ERISA employee benefit plan, maintaining and administering an ERISA-compliant severance plan has costs and burdens, but there are benefits. For example, several benefits of an ERISA-compliant plan include:

• Avoidance of certain risks. If an employer maintains a severance policy or arrangement (even if informal), which may be considered an ERISA plan, bringing it into compliance with ERISA could help avoid the risks of non-compliance described above.
• Administrative consistency and flexibility. An ERISA plan must include details about the key aspects of the severance benefits, which should assist with administering the plan consistently among the employees.
• ERISA preemption and litigation. ERISA cases are generally decided by a judge – not a jury.
• Choice of statute of limitations. Plan sponsors can include a reasonable statute of limitations for filing a lawsuit challenging the plan administrator's denial of a claim in an ERISA plan.
• Complete choice of which employees can participate. Plan sponsor can customize a severance plan for different groups or employees due to the lack of any nondiscrimination rules. However, the employer must be careful not to violate other employment discrimination rules based upon race, sex, national origin, or other factors.
• Formal claims and appeals procedures. An ERISA plan is required to include claims and appeals procedures, and participants are generally required to exhaust these procedures before filing a lawsuit. If the plan follows its ERISA claims procedures, the court will generally overturn the employer's decision only if the employer acted in an arbitrary and capricious manner.
• Choice of law and venue. The ERISA plan document can indicate which state law and venue apply.

State Law Requirements

Severance arrangements that do not qualify as ERISA plans are subject to state law, which can leave an employer at both a substantive and a procedural disadvantage. State law requirements can vary from state to state, which makes compliance difficult. In addition, many of the applicable state laws, such as state wage payment and collection laws, include provisions that expose an employer to substantial risk in a lawsuit for nonpayment, including in some states punitive damages, jury trials, and potential personal liability for company officers.

What are the Risks of Not Complying With ERISA?

If an employer's severance policy is determined to be subject to ERISA and ERISA's requirements have not been followed, the employer, and the plan fiduciaries, could be subject to various penalties and potential claim exposure. For example:

• DOL/IRS Penalties. Failing to file the Form 5500 could lead to an IRS penalty of $25/day up to a maximum cap of $15,000. Additionally, this failure could lead to a DOL penalty up to $1,100 per day – no cap. There are also certain DOL penalties for failing to provide a summary plan description or other plan information to a participant when requested (up to $110 per day, per violation).
• Participant Claims. A participant could complain to the IRS or DOL or bring breach of fiduciary duty claims or claims for benefits not received (and obtain civil penalties).
• Criminal Penalties. In extreme cases, criminal penalties could be imposed for willful violations of ERISA.

Watch Out for the "Accidental" Retirement Plan

When adopting severance arrangements employers should be careful not to accidentally create a pension plan. Under ERISA, the severance arrangement will likely be considered a pension plan if payments are:

• Contingent directly or indirectly upon retirement;
• The total amount of payments exceeds two times the employee's annual compensation; and
• All payments are not completed within 24 months after termination.

If the severance arrangement is determined to be a pension plan, it will be subject to various funding, vesting and trust requirements that are not otherwise imposed on welfare plans.

Even if an ERISA pension plan is not intended, an employer could accidentally create one by having a regular practice of paying severance, especially when such payments are based on internal policies or procedures designed to maintain consistency or to omit the discretion of human resources personnel. The risk in these situations is that without a formal ERISA plan document, the employer is subject to a court's discretion in determining what benefit payments may be due to a particular former employee or group of employees. And, prior employer practices can be determinative of what payments under the arrangement should be in the future. Additionally, "accidental" plans may fail to meet ERISA's reporting and disclosure requirements, which can result in costly penalties as noted above.

Internal Revenue Code Section 409A May Also Apply to Severance Plans

Certain severance arrangements can be considered a form of deferred compensation. This means that employers must be careful to ensure that the severance arrangement either complies with Section 409A's requirements or meets one of its exceptions. The consequences of violating Section 409A are significant for employees from a tax perspective. Individual employees who receive payments under a plan that is subject to Section 409A and does not comply with Section 409A's requirements may have to pay income tax on the amount deferred, interest, and an additional tax of 20%. Employees who are subject to such penalties will often seek reimbursement from their employers alleging they did not properly consider the implications of Section 409A when designing the severance plan. Further, employers may find themselves exposed to these taxes under the employment tax reporting and withholding requirements.

Where Do Plan Fiduciaries Go from Here?

The application of ERISA to informal severance plans is an issue that is commonly overlooked by employers. To mitigate the risk of costly compliance errors, employers should carefully review their severance packages and determine whether they are subject to ERISA and/or Section 409A. For any arrangement determined to be an "ERISA Plan," employers should make sure that the plan meets the various requirements of ERISA or Section 409A, and that proper procedures are in place to ensure continued compliance. Employers paying severance to terminating employees should also evaluate the benefits of adopting a formal ERISA severance plan as compared to the risks of maintaining a non-compliant severance policy or arrangement.

Footnotes

1. 29 U.S.C. 1002(1).

2. Fort Halifax Packing Co., Inc. v. Coyne, 482 U.S. 1 (1987).

Originally Published in Employee Benefit Plan Review

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.