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Employee Benefits Law Report

Reporting on recent trends and developments affecting employee benefits

The $36,500 per employee, per year, per mistake PPACA penalty

Posted in Health Care Reform

And the gloves are off! The IRS has threatened employers with PPACA penalties of $36,500 per employee, per year, nondeductible. Makes those $2,000 and $3,000 penalties look like small potatoes, right?

The targets of this particular Q&A are employers who maintain “non-integrated” “employer payment plans.” These are new terms, which include reimbursement plans such as health reimbursement arrangements (HRAs, excluding retiree-only and excepted benefits HRAs). Those should generally have been eliminated by January 1, 2014, or amended to be integrated with group health coverage. The federal agencies dropped this bomb on employers on the cusp of open enrollment season last year, and many employers had to scramble into compliance. You could have done the math on the $100 per day excise tax. But the IRS puts this $36,500 figure into a Q&A for a reason: it wants to scare you. And employers need to know that a non-integrated employer payment plan is just one of many potential triggers of these potentially devastating excise taxes.

When I first blogged about health care plan self-audit, self-correction, and self-reporting compliance issues on Form 8928, no one seemed too interested. It’s time to get interested.

 

 

 

 

 

 

ERISA Section 510: wanting to be a participant, versus being a participant

Posted in ERISA Litigation, Retirement Plans

My assistant informed me that my patience is shot and I need to do something about that, so I am channeling my energy into one issue. Since health care reform was enacted, I have been hearing about how we should anticipate a flood of ERISA Section 510 (29 U.S.C. Section 1140) discrimination cases from people who are not participants under the plan terms, but want to be participants. I don’t get it.

ERISA Section 510 provides, “[i]t shall be unlawful for any person to…discriminate against a participant or beneficiary…for the purpose of interfering with the attainment of any right to which such participant may become entitled under the provisions of an employee benefit plan.” ERISA Section 3(7) defines “participant” as “any employee or former employee of an employer, or any member or former member of an employee organization, who is or may become eligible to receive a benefit of any type from an employee benefit plan.”

In Firestone Tire & Rubber Co. v. Bruch, the United States Supreme Court first considered Section 3(7) (29 U.S.C. Section 1002(7)) in the context of standing. It found this term to include “employees in, or reasonably expected to be in, currently covered employment,” or former employees who “have . . . a reasonable expectation of returning to covered employment” or who have “a colorable claim” to vested benefits.  The Court held that in order to establish that he or she may become eligible for benefits under ERISA Section 502, a claimant must have a colorable claim that (1) he or she will prevail in a suit for benefits, or that (2) eligibility requirements will be fulfilled in the future. The Court applied the same standard to Section 104(b)(4), the provision that requires providing plan documents that indicate whether or not an individual is eligible to participate to a person who claims to be eligible.

As Justice Scalia explained in an opinion concurring in part and concurring in the judgment, this definition ignores the fact that some of these supposed participants and beneficiaries are not actually participants and beneficiaries. Consider competing claimants to a 401(k) plan death benefit:  a same-sex spouse not designated as a beneficiary, and a parent designated as beneficiary. One of these will ultimately be found to be a beneficiary, and the other will not. But both will be treated as beneficiaries for purposes of making their case.

In Fleming v. Ayers & Assoc., the Sixth Circuit held that where an employer hired a part-time employee with the [employer’s] intent that she would become full-time when a position opened up, the employee was a participant under ERISA Section 3(7) and for purposes of Section 510. The Court did not further explain this conclusion, or discuss Firestone or Justice Scalia’s caution. A number of courts have distinguished Fleming, explaining that ERISA Section 510 does not require employers to make a part-time employee who is ineligible for benefits a full-time employee and thereby eligible for benefits. See, e.g., Geist v. Gill/Kardash P’ship, LLC, 671 F. Supp. 2d 729  (D. MD 2009) (plaintiff was not a full-time employee and was not eligible for benefits under the plan terms; plaintiff rejected a forty hour per week full-time schedule on more than one occasion and seems to have understood that this decision disqualified her for benefits); Pine v. Crow, 2001 U.S. Dist. LEXIS 8629 (S.D. IN 2001) (ERISA does not require an employer to make an employee full-time); Shawley v. Bethlehem Steel Corp., 784 F. Supp. 1200, 1203 (W.D. Pa. 1992) (concluding ERISA does not expressly prohibit a refusal to hire based on the employer’s potential benefit liability), aff’d, 989 F.2d 652 (3rd Cir. 1993).

Now let’s consider the ERISA claims in Sanders v. Amerimed, Inc., a recent decision in the Southern District of Ohio. Sanders was a part-time employee and not a participant in the health care plan, because the plan’s eligibility provisions provided that only full-time employees were eligible to become participants. Sanders wanted to be a full-time employee, and he wanted to be a participant, and quit. He then argued that the defendant violated ERISA Section 510 by not hiring him into a full-time position. The Court held that under Firestone and Fleming, Sanders had a colorable claim to benefits and standing to pursue his claims. The Fleming decision seems to be overreaching; it does not explain the significance of “intent” in the context of case law. But even if we assume the conclusion was valid, it does not appear to provide authority for treating Sanders as anything other than a participant want-to-be. Sanders was well aware he was not a plan participant: that is why he quit. So I do not understand how he even had a colorable claim to benefits, but for the sake of argument, let us move on to the Section 510 claim itself.

The definition of “participant” in Section 3(7) is just the beginning; ERISA goes on to develop this concept in Section 202 (29 U.S.C. Section 1052) and other provisions. The steps require asking whether under the plan terms, as limited by law:

  1. Is the employee a member of a classification that is eligible to participate?
  2. Has the employee satisfied any age requirement?
  3. Has the employee satisfied any service requirement?
  4. Has the employee reached an entry date?

Continue Reading

Sixth Circuit retiree health care case to be heard by the U.S. Supreme Court

Posted in Health Care Reform, Retirement Plans

The U.S. Supreme Court has agreed to hear a Sixth Circuit retiree health care case, M&G Polymers USA, LLC v. Tackett. The issue is:

Whether, when construing collective bargaining agreements in Labor Management Relations Act (LMRA) cases, courts should presume that silence concerning the duration of retiree health-care benefits means the parties intended those benefits to vest (and therefore continue indefinitely), as the Sixth Circuit holds; or should require a clear statement that health-care benefits are intended to survive the termination of the collective bargaining agreement, as the Third Circuit holds; or should require at least some language in the agreement that can reasonably support an interpretation that health-care benefits should continue indefinitely, as the Second and Seventh Circuits hold.

The decision to take this case was announced within two weeks of the Sixth Circuit’s publication of its retiree health care decision in United Steel, Paper and Forestry, Rubber, Manufacturing Energy, Allied Industrial And Service Workers International Union, AFL-CIO-CLC v. Kelsey-Hayes Company. Coincidence? I don’t think so. In a concurring and dissenting opinion in Kelsey-Hayes, Judge Sutton expressed concern that the Court was improperly handcuffing employers, and that is a concern shared by many. In its Yard-Man inference line of cases, the Sixth Circuit has handcuffed employers to providing free lifetime health care benefits in a manner that no other circuit has followed. M&G Polymers is not going to resolve the issue of what benefits must be provided (Judge Sutton’s concern), but it will resolve the inconsistency among the circuits regarding the most basic presumption about collective bargaining agreements. This will be an important decision for employers struggling to manage costs while implementing health care reform.

Participant document requests under ERISA: throw the crystal balls away! Sixth Circuit adopts “clear notice standard”

Posted in ERISA Litigation

“Can I have all documents related to my retirement plan benefit?” If you are involved with administering an ERISA-governed plan, you have probably received this type of vague request. After reading your crystal ball, you might assume the participant wants a summary plan description and perhaps a copy of the plan document. While that seems reasonable, the problem with these types of vague requests is that if your crystal ball happens to be foggy on a particular day, you could face penalties of up to $110 per day for not providing the requested materials. Thankfully, the Sixth Circuit Court of Appeals has taken a common-sense “clear notice standard” approach to resolving these issues, which helps eliminate the need to rely on clairvoyance and crystal balls.

These types of broad document requests are often made during the formal claim/appeal process, as was the case in Cultrona v. Nationwide Life Ins. Co. At issue in Cultrona was whether the participant was entitled to statutory penalties under ERISA Section 502(c)(1)(B), which gives courts discretion to penalize plan administrators up to $110 per day if they fail to provide certain plan-related documents within 30 days of receiving a written request. Following the denial of her claim for benefits under the company’s death benefit plan, the claimant’s attorney requested “all documents comprising the administrative record and/or supporting [the plan’s] decision.” While the plan administrator provided some documentation, it did not provide a copy of the written plan document until seven months after the initial request. Because the terms of the plan document were the primary basis for the claim denial, the district court determined that the administrator should have provided a copy in response to the request. The court then imposed a penalty of $55 per day ($8,910 total) on the plan administrator for failure to timely provide the document.

On appeal, the plan administrator argued that the court should adopt the “clear notice standard” for determining if it was required to provide the plan document to the claimant. Under this standard, individuals requesting plan-related documents that they are entitled to under ERISA must “provide clear notice to the plan administrator of the information they desire.” The key question here is whether the plan administrator knew, or should have known, which documents were being requested. If so, the plan administrator has a duty to provide the documents and faces penalties of up to $110 per day if it does not provide the documents within 30 days of the request. Even though the claimant’s request was broad, the Court ultimately agreed with the district court that the plan administrator should have known that the claimant wanted a copy of the plan document under the circumstances. Thus, the plan administrator was required to pay the statutory penalties.

While the adoption of the “clear notice standard” is not particularly enthralling or surprising, there are a few nuggets of wisdom buried in this decision. First, while courts do not expect plan administrators to rely on crystal balls, plan administrators should use some common sense when responding to participants’ document requests. It seems like a no-brainer (at least to this court) that a claimant would want a plan document when that was the basis for the claim denial.

Second, when in doubt, ask for clarification. Even more compelling than the adoption of the new standard was the Court’s logical statement that “a plan administrator is free to place the burden of clarity squarely on the requester simply by replying to an ambiguous demand for . . . documents with the administrator’s own request for greater specificity.” In elementary school, we were all told that there are no stupid questions. While some may argue with that old adage, I would submit that the same applies when trying to figure out what a participant is asking for. If you do not know, it is better to ask for clarification then to face potentially steep penalties for not providing the right documents.

We have seen situations where participants really need documentation; they just cannot find the right words to adequately describe what they need. In these situations, we believe the plan administrator has a duty to help the participant. But we have also seen abusive situations. For example, a participant (or more likely, the participant’s legal counsel) makes an ambiguous request that appears to be designed to try to seek penalties later. This is an example of where it is perfectly appropriate to ask for clarification before embarking on a photocopy project.  Another scenario is where a participant makes an overly broad demand as a form of harassment.  In that scenario, we would suggest that you provide what the participant is entitled to, and explain the limitations of the disclosure. In any scenario where you suspect an abusive purpose, you may want to consider asking the participant (or his counsel) to write back if he believes he is entitled to any additional documentation that was not provided, and to provide an explanation as to why he is entitled to this additional documentation. Abusive situations like this are fairly unusual, but requiring a participant to play by the rules rather than inappropriately drive up costs is in the best interests of all plan participants.

Health reimbursement accounts failed to satisfy collective bargaining agreement provisions: is the Sixth Circuit handcuffing employers?

Posted in Employment Issues, Health Care Reform

We have a new Sixth Circuit decision regarding “vested” retiree health care benefits that is likely to be of concern to many employers, United Steel, Paper and Forestry, Rubber, Manufacturing Energy, Allied Industrial And Service Workers International Union, AFL-CIO-CLC v. Kelsey-Hayes Company. You may recall that in the last significant Sixth Circuit decision on this topic, Reese v. CNH America LLC, the Court recognized that health care had changed over the years, and concluded that the employer could unilaterally modify a retiree health plan, provided that the modifications were reasonable.  That decision seemed to put the Sixth Circuit more in line with other circuits that had ruled on these issues, and gave employers some relief.  But it appears that relief was short-lived.

Oversimplifying this a bit, the 2003 Kelsey-Hayes collective bargaining agreement provided that retirees would be provided with establish a health insurance plan, “either through a self-insured plan or under a group insurance policy or policies issued by an insurance company . . . .” and “The Company shall contribute the full premium or subscription charge for health care coverages.”  The agreement contained a provision regarding changing benefits, but those changes were required to be made by mutual agreement. Plaintiffs worked for a plant that was shut down in 2006.  In 2012, TRW Automotive, which had purchased Kelsey-Hayes, announced that it was eliminating its traditional group health care plan coverage. It was establishing health reimbursement accounts (“HRAs”). With respect to this group, it made an initial contribution of $15,000 per retiree and spouse, and promised a $4,800 credit for each retiree and spouse for 2013, with no commitment regarding subsequent years. The company retained the right to cease providing retiree coverage.

In Kelsey-Hayes, the Court (in a majority opinion written by Judge Griffin) concluded that the employer did not have the authority to create health reimbursement accounts that it promised to fund for only two years, and to reserve the right to eliminate all coverage thereafter. The Court found TRW liable as a successor for the collective bargaining agreement commitment. In an opinion concurring in part and dissenting in part, Judge Sutton agreed with this much of the of the opinion. The majority opinion further explained that reasonable modifications were only permitted in CNH America because of the text of the collective bargaining agreement and issued a permanent injunction, “requiring a return to the ‘status quo ante.’” Judge Sutton, who had written the CNH America opinion, by the way, disagreed, reminding us that the Court had said:

Retirees, quite understandably, do not want lifetime eligibility for the medical-insurance plan in place on the day of retirement, even if that means they would pay no premiums for it. They want eligibility for up-do-date medical insurance plans, all with access to up-to-date medical procedures and drugs.

Judge Sutton viewed the injunction as improperly ruling that even if the company had agreed to fund the HRAs for life, and even if the individuals obtained better and more flexible coverage, this would not satisfy the company’s obligation. He characterized this case as highlighting “the perils of handcuffing a company to one mode of providing retiree benefits.” This opinion explains that participants were guaranteed access to an individual insurance plan, and provided with a broker to select an insurance package. It appears that the Treasury, DOL and HHS already handcuffed the company from doing this in 2014 and beyond (see, e.g., IRS Notice 2013-54). But does this decision mean that if the company maintains a defined contribution private exchange, it must maintain a standalone insured plan for this group of retirees? Stand-alone retiree plans are excepted from the Patient Protection and Affordable Care Act (“PPACA”), which means the retirees could lose benefits they would have had (such as coverage of preventive care and coverage of dependents to age 26). Further, presuming the stand-alone plan is affordable and provides minimum value, the retirees will be ineligible to purchase, with a premium credit and cost-sharing reduction, an individual exchange policy that might include better benefits under the minimum essential coverage rules. This brings us back to the question: do retirees really want 2006 health care?

In a concurring opinion in Kelsey-Hayes, Judge Merritt opines that the Court is not handcuffing the employer, as the opinion only applies to the present circumstances, and there are many ways circumstances could change in the future. Like implementation of PPACA, perhaps?

Employers are continuously reviewing their employee compensation and benefits costs, and determining how much total cost they are willing and able to bear. Many employers are exploring, or have already made, significant changes regarding health care benefits. In 2018, the 40% nondeductible excise tax (Cadillac tax) is anticipated to hit many plans maintained pursuant to collective bargaining. Determining how those plans will be redesigned to minimize the tax, or how this tax will be funded, is critical. Employers, especially those in the Sixth Circuit, may be handcuffed by collective bargaining agreements and have trouble extending those changes to employees and retirees protected by those agreements. Accordingly, we continue to urge employers to make health care coverage a priority in the collective bargaining process. Employers may not be able to do anything about collective bargaining agreements that were in existence prior to an acquisition (and this is one of the reasons why due diligence is so important), but they may be able to better protect their interests in current negotiations.

“Substantial risk of forfeiture” clarification impacts tax-exempt and governmental employer non-compete arrangements

Posted in Tax-Exempt/Governmental Employers

One of the more interesting (or frustrating, depending on your point of view) things about language is how sometimes, the same word can have multiple meanings. As Michael Jackson once showed us, “Bad” can sometimes mean bad, and sometimes it can mean good. In the executive compensation world, “substantial risk of forfeiture” is a term that can have different meanings, depending on whether Code Section 83, 409A, or 457(f) is defining it. Understanding this concept is important because regardless of the Code Section, the compensation at issue generally does not become taxable to the employee until the substantial risk of forfeiture lapses. It can get confusing trying to determine whether a condition imposes a substantial risk of forfeiture in one Code Section, let alone in three different Code Sections.

We previously blogged about how the IRS and Treasury recently issued final regulations that clarify the definition of substantial risk of forfeiture for purposes of Code Section 83. These blogs, similar to the final regulations, focus mostly on restricted stock grants and certain stock option grants. An important point that has flown somewhat under the radar is that these regulations also could affect tax-exempt and governmental employers who have entered into non-compete arrangements with current and former employees.

That may sound surprising at first, because Code Section 83 does not specifically address tax-exempt organizations. These types of arrangements are governed instead by Code Section 457(f). The regulations under Code Section 457(f) currently state that “substantial risk of forfeiture” is defined in the manner provided under Code Section 83. Consequently, any change or clarification in the Code Section 83 regulations will impact Code Section 457(f). In particular, the Code Section 83 regulations continue to allow certain non-compete arrangements to be considered a valid tax-deferral mechanism.

Where things become confusing is that several years ago, the IRS issued guidance stating that it intends to issue new regulations under Code Section 457(f) that are more consistent with the Code Section 409A regulations. Code Section 409A also has a substantial risk of forfeiture concept. Unlike Code Section 83, the regulations under Code Section 409A state that a non-compete arrangement will not be considered a substantial risk of forfeiture that will defer taxes. Instead, the IRS will disregard any non-compete when determining whether compensation is subject to a substantial risk of forfeiture.

When the IRS issued this guidance, most tax-exempt and governmental employers began to focus more on the Code Section 409A regulations than on the Code Section 83 regulations with respect to their deferred compensation arrangements. Specifically, they made sure that these arrangements contained service or performance-based vesting conditions that would be considered a valid risk of forfeiture that deferred taxes.

We still encourage this practice. Service and performance-based conditions impose a valid substantial risk of forfeiture under Code Section 83 too. It’s also a smart practice to be forward-thinking rather than reactive. Yet, sometimes these types of conditions may not be appropriate. A common example is where an organization wants a current executive to take a step back to allow a successor to take over his or her position, while still being available for consulting if questions arise. Until the IRS issues final regulations under Code Section 457(f), a non-compete, particularly if it is combined with this type of part-time consulting arrangement, could still be a valid tax-deferral mechanism. One caveat is that in order for a non-compete to impose a substantial risk of forfeiture that defers taxation, the facts and circumstances must show that (i) given the employee’s age and employment opportunities, the non-compete imposes a legitimate burden, and (ii) the employer intends to enforce the non-compete.

A common example is the president or executive director of a large non-profit organization. Often times, these executives will be required to satisfy a service condition in order to receive deferred compensation (e.g., remain continuously employed for a period of 5 years). The executive also will be subject to a non-compete agreement that states that as long as the executive is employed at the organization and for a period of time after termination of employment (typically 1-2 years), the executive will not serve as an executive officer or director of a competitor organization within a certain radius of the employer. Failure to abide by these terms will require the executive to repay the deferred compensation amounts to the employer.

In short, the Code Section 457(f) regulations may one day eliminate any tax advantage of using non-compete arrangements. That day is not yet here, and until then, tax-exempt and governmental employers should remember that the Code Section 83 regulations still preserve some flexibility with using non-compete arrangements.

 

Join us April 29 for our Employment Relations Seminar: Keeping Your Workplace Healthy, Wealthy and Wise

Posted in Events, Health Care Reform

 

Join Porter Wright’s Employment Group for our Spring Employment Relations Seminar -Keeping Your Workforce Healthy, Wealthy and Wise – on Tuesday, April 29, 2014 in Cleveland.

Topics include:

Keeping Pace: Learn the Latest in Employment Law presented by Tracey L. Turnbull

De-Stress: Effectively Managing Mental Stress Claims in Workers’ Compensation Cases presented by Fred J. Pompeani

Shaping Up: Getting Your Health Care Reform Plan and Your Workforce in Shape for 2015 presented by Ann M. Caresani

Making Peace: Resolving Workplace Conflict Through An Alternative Dispute Resolution Program presented by Margaret M. Koesel

This program has been submitted for 3.0 hours of continuing legal education credit with the Ohio Supreme Court and 3.0 hours of credit through HRCI.

Register here

There is no charge for this seminar; however, seating is limited.
Please register now.

If you have any questions, please contact Erin Hawk.

Tuesday,
April 29, 2014

7:45 a.m. – 8:30 a.m.
Registration

8:30 a.m. – 11:45 a.m.
Program

Lockkeepers Restaurant
8001 Rockside Road
Valley View, Ohio

 

IRS Safe Harbor for accepting rollover contributions – Revenue Ruling 2014-9 and Form 5310

Posted in Tax Issues

The Form 5310 Application for Determination for Terminating Plan instructions, updated in December 2013, added an odd and time-consuming new requirement, “Submit proof that any rollovers or asset transfers received [during the year of plan termination and five prior plan years] were from a qualified plan or IRA (for example, DL [determination letter] and timely interim amendments).”

The reason we find this instruction odd is that we are not aware of any requirement for a plan administrator to obtain and retain this proof. Treasury Regulation Section 1.401(a)(31)-1, Q&A-14 provides a safe harbor for the reasonable acceptance of a rollover that is later found to be invalid. Under this safe harbor, an invalid rollover would be treated as valid provided the administrator reasonably concluded the rollover was a valid rollover distribution, and distributes the amount with attributable earnings to the participant within a reasonable time of determining that the rollover was actually invalid. This protects the qualified status of the plan. The regulation set forth examples of how an administrator could make a reasonable determination. None of these examples required the administrator to prove the distribution was from a qualified plan or IRA, or to obtain a determination letter and timely interim amendments. So even if the administrator were attempting to rely on the safe harbor with respect to an invalid rollover, which is not what is happening when the employer requests a determination letter, the administrator would not have that type of documentation.

Subsequently, in Revenue Ruling 2014-9, the IRS set forth additional examples about how an administrator could comply with the safe harbor.  In the first example, for a rollover from one qualified plan to another, the administrator simply went to the DOL website to check the most recently filed Form 5500 for the distributing plan.  The administrator confirmed that Code 3C did not appear on Line 8a, as that would have indicated that the plan was not intended to be qualified. In the qualified plan and IRA rollover examples, the administrator receives a check that indicates the qualified plan or IRA distribution is for the benefit of the employee, and an “attached check stub” indicating the source of the funds. Further, the employee provides a certification regarding the taxable nature of the distribution.  In the event the administrator later learns the rollover was invalid, it distributes the amount with attributable earnings to the participant within a reasonable time of such determination.

Keep in mind, these are just examples. The fact that the guidance does not address more modern day scenarios, like wire transfers, does not necessarily mean that an administrator should  demand a check rather than a wire. Further, this guidance merely sets forth a safe harbor, not a requirement.  Finally, we hope the IRS will strike the qualified plan or IRA “proof” requirement in the Form 5310 instructions, but no word on that yet. In any event, we advise plan administrators to establish solid practices for the acceptance of rollover contributions, to help protect the qualified status of their plans.

Substantial risk of forfeiture guidance clarifies when Section 16 short-swing profit liability can defer taxation of equity compensation awards

Posted in Tax Issues

Legend had it at my law school that one day, a lost student walked into a torts class and asked the professor if this class was wills, trusts, and estates. The torts professor replied, “We haven’t gotten that far yet.” A dry sense of humor on the professor’s part? Perhaps. His point, however, was that the law can be a seamless web, with one area of law often having an impact on another. This point often is true with respect to the tax and securities laws.

We blogged previously that the IRS and Treasury issued final regulations under Code Section 83 to “clarify” the definition of “substantial risk of forfeiture” with respect to restricted stock (and other property) grants. One of the clarifications was that transfer restrictions, in and of themselves, do not constitute a substantial risk of forfeiture. For taxation to be deferred on restricted stock grants, the stock must be both non-transferrable and subject to a substantial risk of forfeiture. An example might help illustrate this point. Suppose that a company grants its CEO restricted stock that vests on the fifth anniversary of the date of grant, provided that the CEO has been continuously employed through that date. Also suppose that the CEO satisfies this vesting condition, but on the vesting date, the company’s insider trading policy prohibits the CEO from selling the shares for several months. The CEO would be taxed on the value of the shares on the vesting date, despite the fact that the CEO is unable to sell the shares.

The Code Section 83 regulations, both before and after the clarification, contain an important exception to the non-transferability rule. This exception arises mostly with stock option grants, rather than restricted stock grants, even though restricted stock grants are more often impacted by Code Section 83. That exception is the subject of this blog. Continue Reading

Supreme Court unanimously holds that severance payments generally are subject to FICA taxes

Posted in Executive Compensation, Tax Issues

Clients frequently ask us if severance payments are subject to tax withholding. The answer is that they clearly are subject to income tax withholding, but there has always been some ambiguity about the circumstances in which they are subject to FICA tax withholding. The IRS has always taken the position that severance payments are not subject to FICA tax withholding only when the severance payments are tied to the receipt of unemployment benefits. When the issue arose in litigation, however, the Circuits were split as to whether to side with the IRS, or whether a somewhat broader FICA exception should apply in certain cases involving bankruptcies or reductions in force.  During the past few years, many employers and employees filed refund claims for FICA taxes withheld on severance payments, with the hope that the Supreme Court would issue a decision in favor of the broader exception.

Last week, the U.S. Supreme Court unanimously held in United States v. Quality Stores, Inc., that the IRS position was correct, dashing the hopes of any refunds.  As such, severance payments generally are subject to FICA taxes. The only exception that the Court preserved was for supplemental unemployment benefit (“SUB”) plans under Code Section 501(c)(17), where severance benefits are tied to the receipt of unemployment benefits. For example, suppose that the employer wants to continue to allow a former employee to receive base salary for period of time after severance. Also suppose that a former employee had been earning $700 a week from the employer, and the former employee now receives unemployment benefits are $300 a week. Under a SUB plan, the former employer would pay $400 a week to make the former employee whole.

The Court also noted that even the limited exception regarding unemployment benefits appeared to be inconsistent with the plain meaning of the tax statutes. As such, we would not be surprised if the IRS later reverses its own position to eliminate this exception and require FICA tax withholding on all severance payments, even when they are tied to unemployment benefits.

For now, there is no immediate action for employers to take. As we said previously, if an employer has filed claims for refunds of FICA taxes withheld on prior severance payment, the IRS almost certainly will deny those claims. Otherwise, the case serves as a reminder that employers need to be mindful of the tax and benefits issues surrounding their former employees.