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Contributed by David Fuller, McDermott, Will & Emery LLP
While the coronavirus pandemic wreaked havoc on the economy and jobs, employers considered disaster-related employee benefit structures, such as easily administered qualified disaster assistance relief programs and the financially attractive severance alternative known as “supplemental unemployment benefit plans” or “SUB-pay plans.” Compared to the typical severance program, restructuring a temporary or permanent layoff program as a SUB-pay plan can yield financial and tax savings exceeding 30% of an employer's typical severance costs while also providing FICA tax savings to employees of 7.65%.
Due to the significant cost savings offered by a properly structured and operated SUB-pay plan, these should always be the first step in any analysis when an employer contemplates permanent or temporary downsizing. As contrasted to Section 139 disaster relief payments, the financial and tax attributes associated with a valid SUB-pay plan will require the advice and counsel of experienced tax and employment advisers to navigate the issues associated with SUB-pay. The severance restructuring is generally considered worth the associated efforts and this article provides important background and a roadmap to some of those issues. Once in operation, the plans can be self-administered while navigating and responding to the financial, operational, and human costs raised by the coronavirus.
Although SUB-pay plans have existed for more than half a century, most companies and advisers outside of the steel and automotive industries have little experience with these arrangements. Nevertheless, they can be adopted and implemented with relative ease on short notice in lieu of traditional severance. To achieve the dual financial savings associated with SUB-pay, existing severance structures will need to be carefully modified to conform to the various administrative, statutory, and case law nuances impacting SUB-pay plans that are highlighted in this article.
These changes are often seamless to the terminated worker. If properly drafted and operated pursuant to their terms, an employer with traditional severance costs of approximately $10 million can reduce its out-of-pocket costs by more than $3 million depending on its facts and circumstances, while its employees can receive the same net benefit payment (or more) than offered under a traditional severance.
Severance arrangements generally are drafted without any consideration for their impact on state unemployment benefits. As a consequence, instead of supplementing state unemployment benefits, severance plans have historically disqualified many employees from receiving state unemployment benefits. By contrast and as the name implies, SUB-pay plans are designed to supplement, integrate, or, as the Internal Revenue Service states, “link” with state unemployment benefits. The strength of those design features or links with state unemployment have vacillated over the years. Although SUB-pay plans were almost eliminated by the IRS in the early 1990s, traditional SUB-pay plans have a renewed platform as a result of the Supreme Court's decision in Quality Stores, 572 U.S. 141 (2014). Whether they will exist in five or 10 years will depend on further swings of the pendulum.
The financial savings associated with a SUB-pay plan vary depending on the plan's structure, with one of the most significant variations focusing on whether the plan is an “offset benefit” or “full benefit” plan.
What is an offset plan? The first SUB-pay plans recognized by the IRS were almost all offset plans. In the decade prior to the Supreme Court's decision in Quality Stores, most new SUB-pay plans were full benefit plans. Post-Quality Stores, offset plans are resurging for legal, administrative, and financial reasons. Severance arrangements are typically structured as installment or lump sum payments computed as 100% of a laid-off worker's gross weekly, biweekly, or monthly gross payroll.
By contrast, an offset SUB-pay plan is designed and operated to pay a reduced percentage of gross pay. However, when added to the state unemployment benefits the terminated employee is eligible to now receive, those aggregate amounts will typically approximate 100% of gross wages. The intent is for the employee to receive a termination benefit of approximately 100% of gross payroll wages, but the employer's funding is reduced or offset by the state's payment of the unemployment benefits.
What are the potential financial savings associated with a properly structured offset SUB-Pay Plan? If properly structured, the employee can receive the same benefit payout as regular gross pay, but the state effectively picks up a significant portion of the employer's financial burden. The amount of the burden shifted to the unemployment system will vary but it can exceed 30% depending on variables such as the state, the employee's pay scale and the employee's employment service. With extended unemployment benefits in force, an offset plan can offer even greater financial savings to employers. How an employer utilizes those savings is within its total discretion—options include extending the payout period, providing reemployment incentive payments, or simply retaining the savings in the corporate treasury.
A properly drafted SUB-pay plan offers tax savings regardless of whether it is an offset or a full-pay plan. Significantly, the tax savings exist at both the employer and the employee level. In particular, the tax savings come in the form of reduced employer and employee FICA taxes which in the aggregate are typically 15.3% of the amount paid. These savings can be retained at the employer or employee level or can even be used to extend the payout period for SUB-pay.
In the 1950s, many state unemployment statutes precluded an individual from receiving unemployment benefits for any period in which an employee received any type of wage payment from an employer. The steel and automotive industries and their associated labor unions searched for a solution that would allow employers to provide income supplements when employees were either temporarily or permanently downsized as a result of plant shutdowns, manufacturing retooling, or other similar unemployment periods. Unfortunately, the employer payments were treated as wages with the result that in many states the payments disqualified employees from receiving the very state benefits that the payments were intended to supplement. SUB-pay plans and benefits were structured in coordination with the states, the DOL, and the IRS as a method to bypass these historic disqualification rules by creating benefit plan payments that do not constitute “wages.”
The term “wages” for FUTA and FICA tax purposes means “all remuneration from employment” subject to certain statutory and, to a far lesser extent, administrative exclusions. Although more than 20 statutory wage exclusions exist for these Subtitle C provisions, none of the statutory exclusions references or has ever referenced SUB-pay. Since a statutory exclusion did not exist, the collective negotiations resulted in the IRS adopted new administrative positions and interpretations. Initially released as revenue rulings, the new form of benefit structure known as supplemental unemployment benefits paid benefits that were exempt from the definition of taxable “wages” which all of the negotiating parties agreed accomplished the state law objectives to not disqualify the recipients from receiving state unemployment benefits.
Although almost all tax advisers and SUB-pay administrators focus on the significant FICA tax savings that SUB-pay plans offer, it is critical to note that the FICA tax savings were not the focus of the IRS's early revenue rulings. As the historic origins demonstrate, the true importance of the early IRS SUB-pay rulings was that the characterization of the payments as something other than taxable “wages” necessarily meant that the benefits did not disqualify the employees from receiving state unemployment benefits.
While the original IRS revenue rulings had little to do with FICA tax savings, the secondary and corollary effect of the rulings was to necessarily exempt the payments from wages for FICA, FUTA, and FITW purposes. The rulings resulted in de minimis FICA tax savings to both employers and employees. In fact, the maximum employer FICA tax savings when the first revenue rulings were issued would not exceed $84 per employee since FICA taxes were subject to much lower tax rates and taxable wage bases.
With the exception of two years, the FICA taxable wage base and the tax rates have headed in only one direction—straight up. With these ongoing escalations, the maximum employer and employee FICA tax savings on a SUB-pay plan have increased dramatically. Instead of an annual savings of $84 per employee, the aggregate employer and employee FICA tax savings can exceed $20,000 per year per employee. Although it is a classic scenario of the tail wagging the dog, it is easy to understand why so many tax advisers and third-party administrators focus on the generous tax savings offered by SUB-pay plans. While a properly drafted plan can certainly offer these important tax savings, the plans still are much more than a tax savings vehicle.
Drafting and Administering
While various statutory and case law developments impact SUB-pay structure, the primary drafting consideration of a properly structured SUB-pay plan should focus on various IRS published revenue rulings. This is especially true after the Federal Circuit's decision in CSX Corporation v. United States, 518 F.3d 1328 (Fed. Cir.2008) and the Supreme Court's decision in Quality Stores. The FICA tax savings should be the result, not the focus, of the plan drafting and structure.
Revenue Ruling 56-249
This ruling modified the definition of “wages” for unemployment and FICA/FUTA tax purposes. As indicated, the SUB-pay concept was first identified in rulings from the mid-1950s that were issued to address the concern that downsizing payments should not disqualify employees from receiving state unemployment benefits. Although not the only relevant early IRS ruling, Rev. Rul. 56-249, 1956-1 C.B. 488, is generally considered the most relevant of the IRS's early rulings. Revenue Ruling 56-249 identified a broad exception under existing legal principles from the definition of “wages” for FICA, FUTA, and FITW purposes for payments made upon the involuntary separation of an employee from the service of the employer.
The ruling summarized eight plan features necessary for a plan to pay supplemental unemployment benefits:
• Benefits were paid only to unemployed former employees who were involuntarily laid off
• Eligibility for benefits depended upon meeting prescribed conditions after terminating employment
• Benefits were paid by trustees of independent trusts
• The amount of weekly benefits payable was based upon state unemployment benefits, other compensation allowable under state laws, and the amount of straight-time weekly pay
• The duration of the benefits was affected by the fund level and the employee's seniority
• The right to benefits did not accrue until a prescribed period after termination of employment, i.e., a waiting period prior to commencement of benefits
• The benefits were not attributable to the rendering of particular services
• No employee had any right, title, or interest in the trust fund until such employee was qualified and eligible to receive the trust fund benefits.
The ruling did not assign weight to any specific factor, that weight has been assigned to various factors and has fluctuated over the decades.
The original SUB-pay rulings determined that SUB-pay was not taxable “wages” for FITW purposes even though the SUB-pay benefits (consistent with severance benefits) remained subject to income taxes. It is critical to note that I.R.C. Section 3402(o) statutorily modified the FITW aspects of the IRS rulings. When Congress overrode this aspect of the rulings, it started to use the phrase “supplemental unemployment benefits compensation” or “SUCB” in lieu of supplemental unemployment benefits. While some advisers adopt the SUCB-pay acronym, this article uses SUB-pay throughout based upon the author's role within the IRS National Office while assigned technical responsibility over SUB-pay plans.
Although the entire SUB-pay wage exclusion was almost rescinded as part of the publication process of Rev. Rul. 90-72, 1990-2 C.B. 211, the IRS decided to retain the administrative wage exception while offering an additional interpretation and layer on what constitutes SUB-pay. Rev. Rul. 90-72 continues to recognize a wage exclusion for SUB-pay, however, it rejects the statutory definitions in I.R.C. Section 501(c)(17) and 3402(o), choosing instead to rely solely on the IRS's own administrative definition. Note, although still retaining some, albeit reduced, relevance to the FICA exclusion and state unemployment linkage, the relevance, meaning and effect of these two statutory definitions are beyond the scope of this article post-Quality Stores.
Under Rev. Rul. 90-72, the payments must be made to involuntarily terminated employees, the payments must not be in the form of a lump sum, and there must be a “link” between the plan benefits and state unemployment compensation. The ruling does not revoke or modify Rev. Rul. 56-249. Rev. Rul. 56-249 remains a valid, if not the presumptive, interpretation from the IRS's perspective.
The IRS issued a number of relevant revenue rulings and private letter rulings between these two important IRS revenue rulings. Even though some of the rulings expand what constitutes a SUB-pay plan and have not been subsequently modified by the IRS, many of those rulings have essentially been invalidated by Rev. Rul. 90-72 and subsequent case law.
The Internal Revenue Code has been amended to recognize SUB-pay plans. Congress enacted two important statutes that still impact plan design and operations:
I.R.C. Section 501(c)(17)
This income tax exemption provision formally recognizes SUB-pay trusts. Although not a Subtitle C provision, this code section has practical implications on the design, operation and administration of the SUB-Pay Plan even after the Supreme Court's decision in Quality Stores.
I.R.C. Section 3402(o)
When the IRS recognized the administrative wage exclusion, it originally also provided an exclusion from federal income tax withholding even though SUB-pay benefits have always been subject to federal income taxes, cf. Section 501(c)(17). The FITW exclusion for SUB-pay necessarily created significant administrative issues as the IRS assessed many laid off employees for unpaid income taxes due on the SUB-pay benefits. To avoid such future IRS assessment on unsuspecting workers, I.R.C. Section 3402(o) ensures that the proper withholdings occur.
As a result of the Supreme Court's Quality Stores decision, this article does not discuss the IRS's internal processes or various revenue rulings that were modified to conform to the statutory definition of “supplemental unemployment compensation benefits” found in Section 501(c)(17) and Section 3402(o). Nevertheless, these two separate statutes (one an income tax provision and the other a Subtitle C payroll tax provision) still have relevance in the design, documentation and administration of SUB-Pay Plans that tax advisers must take into consideration when trying to achieve the generous benefits offered by SUB-Pay Plans. Unfortunately, most advisers and plan administrators do not address or consider the relevance of such positions.
A third statute was enacted involving FUTA and extended unemployment. However, the better position post-Quality Stores is that this provision does not impact SUB-Pay Plan operation or design.
Recent court cases have influenced the structure and tax treatment of SUB-pay. Specifically, several federal court cases have addressed SUB-pay operations and design. Two in particular have invalidated many existing SUB-Pay program documents and the method of administration. It appears as though most plans have not been modified in either form or operation to address these important cases.
The Federal Circuit struggled with SUB-pay design when analyzing the relevance of I.R.C. Section 3402(o)’s SUB-pay definition. Recognizing that SUB-pay plan design was nuanced and observing that “the correct resolution of the issue is far from obvious” the Federal Circuit rejected the statutory approach and instead adopted a facts-and-circumstances approach based upon the IRS's administrative rulings.
The U.S. Supreme Court reversed the Sixth Circuit and held that severance payments structured to satisfy the category of SUB-pay benefits defined by I.R.C. Section 3402(o) constitute taxable FICA wages due to the broad nature of the definition of “wages” for FICA tax purposes. Although the Supreme Court questioned and exposed the vulnerability of the IRS’ administrative approach to SUB-Pay, the Court did not overturn the administrative SUB-Pay wage exemption. Since the administrative approach crafted in the 1950s remains intact, the nuances associated with the various IRS published and unpublished ruling position were once again elevated, albeit tempered by the case law and statutory provisions.
As employers and tax advisers address coronavirus-related downsizings, it is absolutely clear that SUB-pay plans remain a viable employment, financial, and tax planning tool that employers should consider as they face difficult labor and financial decisions. While the manner in which SUB-pay plans are drafted and operated has changed significantly over the past decade, SUB-pay plans remain a viable and important method to structure reductions in force while realizing financial and tax savings that can dwarf those offered by traditional severance arrangements.
In contrast to the ease with which Section 139 qualified disaster relief payments can be rolled out, SUB-pay plans will need to be drafted with the advice and counsel of trusted tax and employment law advisers to address issues such as the following:.
• Discrimination issues
• Independent trusts
• Installment versus lump-sum benefits
• Internal or external administration
• Coordinating with the Subtitle C provisions of the coronavirus legislation
• Offset versus full payment plans
• Reemployment incentive payments
• Substitute benefits
• Identify and weigh the relevance of currently applicable IRS factors
• The role of the payroll department
Most existing plans post-Quality Stores have not considered these and other relevant factors. While these may appear daunting to a company seeking the financial and tax savings of a SUB-Pay Plan, advisers should be able to address any questions about these factors with relative ease when developing and rolling out the company's SUB-pay plan.
The relative strengths and merits of each recommendation are beyond the scope of this overview but each factor may have varying levels of importance and weight when achieving an employer's financial savings during these economically tough times. Only the lump-sum payment factor is a de factor barrier, all other elements can be addressed through proper drafting.