Employers that routinely pay severance benefits or expect to pay such benefits in the future as a result of shutdowns, downsizing or seasonal employment may be able to realize substantial Social Security and Medicare tax (FICA) savings for them and their employees by structuring these payments under a supplemental unemployment benefit (SUB) plan. [IRC §501(c)(17)]
For example, assume an employer is forced to lay off 200 employees in connection with a plant shutdown and plans to pay $3,000 in severance benefits to each employee, or $600,000 in total. Normally, the employer would have to pay $45,900 in FICA taxes on these amounts [$600,000 * 7.65% = $45,900] for an effective cost of $645,900.
In order to restructure these amounts as SUB benefits exempt from FICA/FUTA, the $3,000 in severance benefits could be paid to employees in 10 weekly installments of $300 (or other periodic amounts that qualify as SUB benefits) at an effective cost of only $600,000. Employees would save a comparable amount.
What exactly is a SUB plan?
The FICA/FUTA exemption for SUB stems from a series of revenue rulings, in particular Rev. Ruls. 56-249 and 90-72. The overriding theme of these rulings is that the SUB benefits must be designed to supplement state unemployment benefits according to the following requirements.
- Benefits are only paid to those employees who involuntarily separate from employment (e.g., plant shutdowns, reductions in force, etc.) and who meet prescribed conditions after termination of employment, such as registering for unemployment benefits with the state (Rev. Rul. 56-249)
- Benefits are only payable to those employees who satisfy the requirements for state unemployment benefits except if:
- the employee does not have sufficient wage credits under the state law
- the employee has not satisfied the state-required waiting period
- the employee has exhausted the state benefits (Rev. Rul. 90-72)
- Benefits are designed to supplement the state unemployment benefits. In Rev. Rul. 56-249, the benefits were integrated with state unemployment benefits such that the total payments (SUB and unemployment) to the employee were a specified percentage of the employee’s pre-separation straight time take-home pay.
- The benefits are paid periodically and not in a lump-sum distribution [Rev. Rul. 90-72]
- The benefits are paid through a trust or directly to employees through an unfunded program [Rev. Rul. 60-330]
- No employee has an interest in the SUB fund until the employee is qualified to receive benefits [Rev. Rul. 56-249]
While there is planning involved in creating and administering SUB plans, they warrant investigation where the FICA tax savings outweigh the investment. Since long-term severance pay out arrangements help businesses to stay connected to their former employees during transition periods, SUB plans are also worth consideration in situations where businesses believe their workforce needs will return in the future.
Ways to potentially reduce severance pay costs
Employers should keep in mind that there are several areas where severance planning can cut down on unnecessary costs and/or facilitate a continuing connection with separated workers. Here are just a few.
- As previously mentioned, consider supplemental unemployment benefit (SUB) plans
- Properly report severance and salary continuation payments to state employment agencies
- Properly exclude severance and similar payments from wages covered by state unemployment insurance where allowed by law
- Consider state work share programs