United States: Considerations In Designing Severance Plans And Arrangements For Tax-Exempt Organizations

Introduction

There are numerous reasons why organizations exempt from taxation under Internal Revenue Code Section 501(c) (3), as amended (the "Code" and, such organizations, "Tax-Exempt Entities") may offer severance payments to employees who incur involuntary terminations of employment. For example, severance that is conditioned on the departing employee's execution of a release of claims in favor of the Tax-Exempt Entity can reduce the likelihood of costly and burdensome litigation. Similarly, payment of severance may reduce the risk of negative publicity for the Tax-Exempt Entity by diminishing resentment felt by departing employees. Severance may also help retain existing employees by providing them with a measure of economic security that can dissuade them from seeking alternative employment, particularly if they suspect that the Tax-Exempt Entity has encountered budgetary shortfalls and may be implementing near-term workforce reductions. For these and other reasons, many Tax- Exempt Entities have either implemented or are considering implementing severance programs. Tax-Exempt Entities should be aware of unique opportunities and recent IRS regulations that impact the design of severance programs. This article discusses key decisions and planning opportunities for Tax-Exempt Entities to consider when designing and implementing severance plans and individual severance arrangements. Tax-Exempt Entities face a number of legal and regulatory challenges in establishing severance arrangements, particularly with respect to executive-level severance, as discussed in more detail in Part I. Part II discusses the legal parameters around using Code Section 403(b) retirement savings plans to offer severance to employees with lower levels of compensation.

Part I: Bona Fide Severance Plans and Window Programs under the New Proposed Code Section 457(f) Regulations

Taxation of Severance under Code Section 457(f)

Code Section 457(f) generally governs the deferral of compensation payable by Tax-Exempt Entities to their employees. Amounts deferred under a severance plan subject to Code Section 457 are generally taxable to the employee on the later of the first date on which there is a legally binding right to the compensation or, if the compensation is subject to a substantial risk of forfeiture, the first date on which the substantial risk of forfeiture lapses. We refer to this as the "Income Inclusion Rule." Amounts are subject to a "substantial risk of forfeiture"—and therefore are not yet included in taxable income—if entitlement to those amounts is "conditioned on the future performance of substantial services." But the "substantial risk of forfeiture" may lapse—and the attendant taxation event may occur—long before the employee actually receives the deferred income.

Fortunately, the IRS released long-awaited regulations under Code Section 457(f) on June 22, 2016 (the "Proposed Regulations") that provide more detail on how Tax-Exempt employers can structure severance programs to avoid the early imposition of tax due to the Income Inclusion Rule.

The Bona Fide Severance Pay Plan Exemption

Under the Proposed Regulations, a plan or arrangement qualifies as a "bona fide severance pay plan", and is therefore not subject to the Income Inclusion Rule, if it meets all of the following three requirements (the "Severance Plan Exemption"):

Requirement One: Benefits under the plan are only payable upon an involuntary severance from employment or pursuant to a window program (as detailed below).

Requirement Two: The amount payable does not exceed two times the participant's annualized compensation, based on the annual rate of pay for the calendar year preceding the calendar year in which the participant has a severance from employment with the Tax-Exempt Entity (or the current calendar year if the participant had no compensation for services provided to the Tax-Exempt Entity in the preceding calendar year).

Requirement Three: The entire severance benefit must be paid to the participant no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs, pursuant to a requirement contained in a written plan document.

The Proposed Regulations further define "involuntary severance from employment" (for purposes of meeting Requirement One of the Severance Plan Exemption) as "a severance from employment due to the independent exercise of the [Tax-Exempt Entity's] unilateral authority to terminate the participant's services, other than due to the participant's implicit or explicit request, if the participant was willing and able to continue performing services." Whether a severance from employment is involuntary "is based on all the facts and circumstances without regard to any characterization of the reason for the payment by the [Tax-Exempt Entity] or participant."

Additionally, the Proposed Regulations specify that an employee's resignation for "good reason" qualifies as an "involuntary severance from employment," so long as (i) the triggers permitting an employee to resign for "good reason" are pre-specified in writing and meet certain requirements (as described in greater detail below), and (ii) the "primary purpose" of including the "good reason" triggers in the arrangement, or of the actions by the employer that satisfy the "good reason" triggers, is not avoidance of Code Section 457(f).

The Proposed Regulations provide that a resignation for "good reason" will only be treated as an "involuntary severance from employment" if the relevant facts and circumstances demonstrate that the resignation was the result of "unilateral [Tax-Exempt Entity] action" that causes a "material negative change" to the employee's relationship with the Tax-Exempt Entity. The following factors may provide evidence of the required "material negative change": (i) a material reduction in the duties to be performed; (ii) a material negative change in the conditions under which the duties are to be performed; (iii) a material reduction in the compensation to be received for performing such services; (iv) the extent to which the payments upon a resignation for good reason are in the same amount and made at the same time and in the same form as payments that would be made upon an actual involuntary termination by the Tax-Exempt Entity; and (v) whether the employee is required to give the Tax-Exempt Entity notice of the existence of the "good reason" condition and a reasonable opportunity to remedy such condition.

The Proposed Regulations provide a safe harbor definition of "good reason." If a severance plan or arrangement complies with the "safe harbor" definition described in the Proposed Regulations, the plan or arrangement's "good reason" will be deemed to satisfy the involuntary severance from employment condition of Requirement One. On a separate but related note, Tax-Exempt Entities should also bear in mind the private inurement doctrine when crafting severance arrangements for their senior executives. While a detailed discussion of the doctrine is beyond the scope of this article, the general requirement of the doctrine is that severance should not be "excessive." By way of context, a recent national survey of college presidents found that 60% of private universities provide severance to their presidents and, of those that do, over half provided twelve months of severance. However, each Tax-Exempt Entity will need to review the facts and circumstances of its own particular arrangements to ensure it does not violate the private inurement doctrine.

The Short-Term Deferral Rule

Code Section 457(f) provides an exemption from immediate taxation for payments that are made shortly after the right to the payment becomes "vested"—that is, when it is no longer subject to a substantial risk of forfeiture. Generally, if a payment is made not later than March 15 of the year following the year of vesting, taxation does not occur until payment occurs, rather than upon vesting. This rule is commonly known as the "short-term deferral rule." For example, an employee might become entitled to a $50,000 annual incentive payment based on her 2017 calendar year performance. If the incentive arrangement provides that she has a right to receive the payment if she is employed on December 31, 2017, she would have vested in the right to the payment on that date and, absent the short-term deferral rule, would have been required to report $50,000 in income in 2017, even if the bonus was not paid until 2018. Because of the short-term deferral rule, however, if she receives her incentive payment on or before March 15, 2018, the incentive payment will not be taxable until paid. While beyond the scope of this article, making the incentive payment after March 15, 2018, could also raise compliance issues under Code Section 409A unless payment timing was carefully structured.

The short-term deferral rule can also apply in the severance context. Specifically, to the extent severance is paid on or before March 15 following the year of employment termination, the amount payable is not limited to the amount described in Requirement Two above (i.e., two times the employee's annualized compensation). The Severance Plan Exemption and the short-term deferral rule can be combined to structure severance payments such that a portion of the severance is paid during a period later than March 15 of the year following the year of termination under the Severance Plan Exemption and a portion is paid on or prior to March 15 of the year following the year of vesting under the short-term deferral rule, as illustrated below.

Example

Assume a Tax-Exempt Entity is party to an employment agreement with Ms. Smith (the "Smith Employment Agreement"). Pursuant to the Smith Employment Agreement, if the Tax-Exempt Entity terminates Ms. Smith's employment without cause, Ms. Smith is entitled to a severance payment equal to 36 months' continued base salary, payable in equal monthly installments over the three years following her employment termination. Assume further that Ms. Smith received annual compensation equal to her base salary for calendar year 2016. If the Tax- Exempt Entity terminates Ms. Smith's employment without cause on October 31, 2017, the final twelve months' severance (i.e., the amount in excess of two times her 2016 compensation) would be taxable upon her termination if the Severance Plan Exemption were available but not the short-term deferral rule. But using the short-term deferral rule in conjunction with the Severance Plan Exemption allows the full amount of the severance payment to be made without subjecting amounts to tax before payment. Specifically, the Smith Employment Agreement could be designed such that (a) amounts up to two times Ms. Smith's 2016 compensation are paid over the two-year period following her employment termination and (b) amounts which exceed two times her 2016 compensation are paid on or before March 15, 2018. Structuring the Smith Employment Agreement this way results in no taxation before payment, though it does cause the severance to be paid over a shorter period of time (i.e., by October 31, 2019, rather than October 31, 2020).

Window Programs

As noted above, the Proposed Regulations provide that, to meet Requirement One of the Severance Exemption, a severance arrangement must either only provide severance benefits upon an "involuntary severance from employment," or be a window program. Window programs are severance programs established by an employer to provide severance pay in connection with a severance from employment (including a voluntary resignation) during a limited period of time (typically no longer than 12 months).

Window programs may provide severance only to individuals whose termination occurs under specified circumstances during the window period or to all individuals whose severance termination occurs during the window period. A program is not a window program under the Proposed Regulations if it is part of a pattern of multiple similar programs that, if offered as a single program, would not be a window program. In other words, Tax-Exempt Entities cannot establish a rolling series of supposed window programs to circumvent Requirement One of the Severance Exemption. However, if a Tax-Exempt Entity is planning a discrete reduction in force, a well designed window program would permit the Tax-Exempt Entity to incentivize employees to voluntarily resign by offering them severance payments without subjecting such severance payments to the Income Inclusion Rule.

Part II. Post-Termination Contributions to 403(b) Retirement Plans

Tax-Exempt Entities that sponsor a retirement savings plan under Code Section 403(b) ("403(b) Plan") can use a mechanism for providing post-termination payments to their non-highly compensated employees (for 2017, those with compensation under $120,000 in 2016, subject to adjustment in future years) ("NHCEs") without having to grapple with the Income Inclusion Rule, Severance Plan Exemption, and other rules described above. Pursuant to a sometimes overlooked provision of the Code Section 403(b) regulations, if its 403(b) Plan so allows, a Tax-Exempt Entity may continue to make employer non-elective contributions to the 403(b) Plan on behalf of a former employee through the end of the five taxable years following the taxable year in which the former employee ceases to be an employee. Each annual post-employment non-elective contribution must not exceed the lesser of (i) the dollar amount in Code Section 415(c)(1)(A) (i.e., $54,000 for 2017); or (ii) the former employee's annual includible compensation based on the former employee's average monthly compensation during his or her most recent year of service.

In the case of former part-time employees or former full-time employees who were employed for only part of the most recent year, the former employee's "annual includible compensation" during his or her "most recent year of service" is calculated by aggregating the former employee's most recent periods of service until the former employee's service equals, in the aggregate, one year of service. These non-elective contributions, like all contributions to a 403(b) Plan, would not be includible in the former employee's taxable income until they are distributed to the former employee.

Tax-Exempt Entities are advised to offer such post-termination contributions only to NHCEs. The IRS nondiscrimination testing in this area is highly complex and ill-defined, and requires plan sponsors to perform calculations with respect to previous years in which the benefit is offered. Post-termination contributions may even pass non-discrimination testing in one year only to have that year's contributions cause the plan to fail discrimination testing in future years. Note that there is no analogous rule permitting extended post-termination payments under a so-called "401(k) plan" (i.e., a profit-sharing plan with an elective deferral feature). Rules under Code Section 401(k) allow for the deferral of certain post-termination compensation (but not severance pay) during the two-and-a-half-month period following employment termination.

Part III. Conclusion

Tax-Exempt Entities face different challenges and opportunities than do their non-tax-exempt peers in designing severance arrangements. While the Income Inclusion Rule requires careful structuring to avoid immediate income inclusion, the availability of the special 403(b) Plan rule means Tax-Exempt Entities have an additional opportunity to provide tax-deferred severance pay to their NHCEs.

The authors thank Nancy Gerrie, Todd Solomon and Mary Samsa, partners in McDermott Will & Emery's Chicago office, for their assistance in preparing this article.

Considerations In Designing Severance Plans And Arrangements For Tax-Exempt Organizations

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions