(From the March 9, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
Employee Benefits Issues to Consider in a Reduction in Force
As unfortunate as it may be, sometimes the only effective way to increase a company's bottom line during an economic recession is a reduction in force (RIF). The economic analysis should, however, consider much more than just the terminated employees' salaries. Other considerations include nonqualified deferred compensation, stock plans, bonuses, severance pay, retirement plans, health and welfare plans, and FSAs. This article, while not exhaustive, discusses many of the issues an employer may face and thus should consider when performing the economic analysis of a potential RIF.
Nonqualified Deferred Compensation Paid to "Specified Employees": Unless an exception exists, "specified employees" of an entity with stock that is readily tradable on an established securities market may not receive distributions of deferred compensation on account of separation from service until at least six months after the separation occurs (or upon death, if earlier). The term "specified employee" includes officers (limited to the highest paid 50 and excluding anyone who earns less than $145,000 a year (indexed)), five percent owners and one percent owners who earn more than $150,000 a year (not indexed), but there are a number of exceptions and special rules. To comply, the employer will need to delay distributions. Installment or annuity distributions may comply with this requirement either by delaying the commencement of distributions for six months, or by making a catch-up distribution of the first six months of payments at the beginning of the seventh month.
Two important exceptions to the definition of deferred compensation are those for short-term deferrals and separation pay.
A short-term deferral plan is one under which payments are made no later than the 15th day of the third month after the month in which the employee becomes vested in a payment. Lump-sum severance payments available only on involuntary separation from service can fit within this exception and do not have to be delayed. "Involuntary separation" includes certain good reason separations, as provided in regulations. Note, however, for this exception to apply, the plan cannot otherwise provide for a deferred payment. For example, a plan that provides for payment on separation from service after 3 years of employment with accelerated vesting on involuntary termination provides for deferred compensation. Therefore, even if a specific payment is triggered by an involuntary termination, the six-month delay would apply.
A separation pay plan is not subject to the six-month delay to the extent that it satisfies four conditions:
An involuntary separation pay plan that provides for benefits that exceed the dollar cap may designate that each payment is a "separate" pay out of an amount up to the cap during the first six months after separation and the balance at a later time, or can be combined with a short-term deferral plan.
Section 162(m): Section 162(m) of the Code limits the deduction for compensation paid to certain top executives ("covered employees") to no more than $1 million per year. Exceptions apply for "qualified performance-based compensation." To be a covered employee, the executive must be listed on the company's summary compensation table and serving as an officer on the last day of the year (the Principal Financial Officer is exempt). If an executive is terminated, the identity of a company's covered employees will change, and could result in the inclusion of an individual for whom the company did not ensure that the requirements for qualified performance-based compensation were satisfied. As a result, a portion of the deduction for compensation for such an individual may be disallowed.
Incentive Stock Options (ISOs) and Employee Stock Purchase Plans (ESPPs): ISOs and options issued under ESPPs must be exercised within 90 days after an employee's termination for the stock acquired to continue to qualify for the special tax provisions available to these options. After that point, even if they do not expire automatically, they become nonqualified options without any special tax benefits, and any gain on exercise is taxed as ordinary income. Terminated employees with in-the-money options should be reminded of the need for prompt exercise.
Nonqualified Stock Options: While there are no tax rules limiting the exercise of a nonqualified stock option after termination of employment, many employer plans require these options to be exercised within a specified time (e.g., 90 days) after termination of employment. For many employees, the exercise price of the option will be in excess of the fair market value of the stock. In those cases, the employer can extend the expiration date of the option, provided that the extension is not for a period in excess of what the original option terms would be.
Fringe Benefit Plans: Employers may want to consider the creation of tuition assistance, financial planning or relocation assistance plans. Such plans can be offered on a tax preferred basis if certain requirements are met. Generally, these requirements include the existence of an "accountable plan," nondiscriminatory operation of the plan, and substantiation of the expense.
Reductions in force raise a number of issues for qualified retirement plans, some legal and some practical.
Coverage and Nondiscrimination Testing Post RIF: Because a RIF alters an employer's demographics - sometimes dramatically - it may also have an impact on "nondiscrimination" testing for the employer's plans. There is no way to predict the effects in the abstract, but one problem occurs frequently: Many defined contributions plans have a last-day rule, under which contributions are made only for participants who are employed on the last day of the plan year. For coverage and nondiscrimination testing purposes, any participants who leave during the year after completing 500 or more hours of service must be taken into account; if they receive no contributions because of the plan's last-day rule, they worsen the test results. A large number of layoffs can push the plan out of compliance. As a result, additional contributions or changes to the plan may be required.
Matching Contributions: Many employers consider eliminating match contributions as corporate profits are constrained. It is important to be sure that any curtailment does not violate plan provisions. There are limits on the ability of a safe-harbor 401(k) plan to change the level of matching contributions, and if any such change is made during a plan year, employees must receive at least 30 days advance notice before the matching contribution can be reduced. Employees must also be given an opportunity to change their elections in response to the change. For the plan year in which the change occurs, it will be necessary to perform nondiscrimination testing. This will also be necessary for future plan years, if the plan will not be a safe-harbor plan for those years. Plan amendments will be necessary to reflect all of these changes. Note: A safe harbor plan that relies on nonelective contributions to satisfy the safe harbor requirements is more limited in its ability to eliminate the safe harbor nonelective contribution for the year, once the year is underway. A specialist should be consulted for details.
Participant Loans from the Plan Outstanding upon Termination: Participant loans outstanding upon termination of the participant's employment can be treated as repaid with the distribution of amounts from the plan or can remain outstanding. If loan payments have been made through salary reduction, new arrangements will need to be made. If repayments do not continue for ongoing loans, the loan will be in default and the plan will use the account balance securing the loan to satisfy the obligation. In this case, the entire amount outstanding is deemed distributed to the participant. If the participant is under age 55, the deemed distribution will result in a 10% additional tax. Plan documents and administrative policies should be reviewed to make sure that these processes are clear and can be consistently implemented for all employees.
Partial Plan Terminations: A RIF may give rise to a partial plan termination, in which case "affected" plan participants become fully vested. The rule of thumb is that a 20% or greater reduction will result in a partial plan termination, but the facts and circumstances must be evaluated in each case to determine when the partial termination occurred and which participants need to be vested.
Vendor Expenses Related to Terminated Participants: If a vendor's fees are based on an amount per participant, then employers are being charged for each terminated employee that remains in the plan. Alternative pricing structures and factors could be dependent upon the number of participants in relation to their account balances, which would also cause employers to incur expenses for terminated employees that remain in the plan. Finally, fiduciary responsibilities will extend to the former employees that still participate in the plan. To avoid, or at least mitigate these issues, employers should mandatorily cash out account balances that are less than $1,000. The plan document should be reviewed to determine whether account balances in the amount of $1,000 to $5,000 can be distributed without the employees' consent. For account balances in excess of $5,000, communications aimed at convincing former employees to roll their account balances into their subsequent employer's plan or an IRA might be advisable (though an employer may not force former employees with balances exceeding $5,000 to take distributions). Employees receiving distributions must be given the option to roll over distributions into IRAs or other qualified plans; the plan's terms should be consulted for details.
Lump Sum Distributions from Pension Plans: Pension plans that allow accrued benefits to be converted into lump sum distributions may face a major cash outflow following a RIF. The law prohibits amending plans to remove the lump sum option from benefits that have already accrued. On the other hand, it also mandatorily restricts lump sum payouts if benefits were less than 80% funded as of the beginning of the year. Since many plans' funded status declined significantly during 2008, plan sponsors should consult with their actuaries about whether the distribution restrictions will apply in 2009. Some may also wish to consider giving participants the option of starting benefits in annuity form, with the opportunity to cash out the balance when the plan's funding improves and the restrictions are lifted.
Funding Severance Pay from Pension Plan Assets: Instead of paying severance benefits from general assets, a company can substitute enhanced pension benefits: It grants a one-time additional pension accrual equal to the severance pay that would otherwise be due. Laid-off participants are then given the opportunity to take the enhancement as a lump sum or in installments over a one or two year period. If the plan has surplus assets, there is no immediate cash drain on the employer. Even if it doesn't, pension distributions, unlike most forms of severance pay, are exempt from FICA tax. This technique may not be available if the plan is severely underfunded. There are a number of technical issues involved, so expert advice should be obtained before utilizing this technique.
Partial Withdrawal from Multiemployer Pension Plans: An employer that contributes to a collectively bargained multiemployer pension plan may be liable for a partial withdrawal if its contribution base units (the hours worked or other measure used to define its obligation to the plan) decline by 70 percent or more. The reduced level must continue for three years before the plan can assess liability.
PBGC Reportable Events: Plans with 100 or more participants that are insured by the Pension Benefit Guaranty Corporation must report substantial declines in the number of participants to the PBGC, accompanied by an explanation of the cause of the reduction. The notice is triggered when the number of active participants is reduced below 80 percent of the number as of the beginning of the plan year or 75 percent of the number at the beginning of the preceding year. The deadline for filing is 30 days after the date of the reduction, but there are a number of waivers and extensions. The penalty for failure to file is discretionary with the PBGC and can be as high as $1,100 a day.
Funding Pension Liability with Employer Securities: Assuming several requirements are met, employers can cause the plan to acquire employer securities or employer real property without violating the prohibited transaction rules. This could prove useful for purposes of the plan's funding liability. One of the requirements that must be met before the plan can acquire employer securities or employer real property includes the prohibition against contributing securities or real property when the value of such property immediately after the contribution exceeds 10% of the fair market value of the assets of the plan. With respect to employer real property, other requirements exist such that the plan must acquire more than one parcel of real property, the parcels must be dispersed geographically, and each parcel (including the improvements thereon) must be suitable (or adaptable without excessive cost) for more than one use. Numerous other requirements exist for this statutory exemption and thus expert advice should be obtained to avoid the prohibited transaction that could otherwise result.
OTHER SEVERANCE RELATED ISSUES
Accrual of Severance Pay Deductions: Payments associated with severance pay, if made pursuant to a plan, method, or arrangement that defers compensation or benefits, are typically deductible by the employer in the year the amounts are included in the employee's gross income. However, funding a VEBA for this purpose may permit the employer to accrue the deduction in the year contributions are made.
Phased Retirement Instead of Layoffs: As an alternative or supplement to layoffs, companies may wish to consider letting older workers reduce their hours and begin collecting all or part of their pensions in order to maintain the same level of take home pay. Defined benefit pension plans are allowed to start paying benefits to participants who have either reached age 62 or work less than 40 hours a month. Defined contribution plans can start distributions at earlier ages (though 401(k) elective deferrals generally may not be distributed before age 59-1/2).
COBRA: Most employers are required to provide qualified beneficiaries with continued plan coverage upon a qualifying event, including voluntary or involuntary termination of employment or a reduction in hours worked. COBRA coverage that results from termination of employment is available for a total of 18 months (29 months for disabled employees), beginning on the date that coverage would have otherwise lapsed. During this period, qualified beneficiaries must receive the same coverage that is available to similarly situated beneficiaries not receiving COBRA. While beneficiaries may be required to pay for COBRA coverage, the premiums cannot exceed 102% of the cost paid by similarly situated individuals that did not incur a qualifying event.
COBRA eligible employees experiencing an involuntary termination of employment between September 1, 2008, and December 31, 2009, only need to pay 35% of what they would otherwise have to pay for up to 9 months. Employers will be able to recover the additional 65% of the premium that would otherwise be paid in the form of a credit against payroll taxes. If the credit exceeds the employer's payroll tax liability, amounts will be credited or refunded as an overpayment of payroll taxes. Employees that would be eligible for this reduced premium except for the fact that they did not elect COBRA upon termination of employment will have an additional 60 days from the time they receive notice of the law change to elect COBRA. The maximum duration of time for which an involuntarily terminated employee is eligible for the reduced premium is 9 months. This government subsidy of the premium is reduced for taxpayers with adjusted gross income of $125,000 ($250,000 in the case of a joint return), and is not available for taxpayers whose modified adjusted gross income exceeds $145,000 ($290,000 in the case of a joint income tax return). These taxpayers may want to waive the right to the lower premium so that they are not required to repay this amount when they file their annual income tax return. While the effective date of this premium subsidy is generally March 1, 2009, eligible employees can still be billed the full COBRA premium for April and May of 2009 with adjustment for the overpayments made in succeeding months.
Flexible Spending Accounts: Medical expenses incurred after separation from service are eligible for reimbursement from a health care flexible spending account only if the employee continues to make contributions. Doing so is often unattractive, since there is no way to contribute on a pre-tax basis if one is receiving no compensation from the employer. If an employee has a large balance, however, he or she may elect to continue in the FSA so that post-termination expenses are eligible.
Expenses incurred before separation are reimbursable up to the full amount that the employee would have contributed if he had stayed for the entire year. How much was actually contributed before terminating employment doesn't matter.
Supplemental vs. Regular Wages: The amount of withholding on payments depends on whether payments are considered supplemental or regular wages. A mandatory flat rate of withholding equal to the highest rate of tax applies to supplemental wages paid to an employee that, for the calendar year, exceed $1 million. Assuming certain conditions are met, employers may elect to use the "optional flat rate" method of withholding for annual supplemental wages that do not exceed the $1 million threshold. If these conditions are not met, then only the "aggregate procedure" of withholding is available for supplemental wages amounting to less than $1 million.
In general, severance pay will be considered supplemental wages, because it is not based on services performed in the current payroll period (i.e., it is paid after termination).
Supplemental Unemployment Benefits (SUB): Severance pay is generally subject to employment tax, but there is an exception for supplemental unemployment benefits that meet criteria prescribed by the IRS. In general, severance payments are exempt from employment taxes if paid only when the former employee meets the conditions for state unemployment insurance. They must be paid in installments rather than a lump sum. A SUB program can result in significant employment tax savings for the employer and its laid-off employees, but verifying eligibility imposes administrative burdens.
OTHER ISSUES AND CONSIDERATIONS:
Multinationals and Global Mobility Structures: Multinationals with global mobility structures will most likely need to reevaluate the movement of employees around the globe. The resulting mobility structure will depend on each entity's facts and circumstances. In general, the entity may consider bringing people home from abroad, moving US expats around overseas, or sending US employees overseas.
Workers Adjustment and Retraining Notification (WARN) and Parallel Foreign Requirements: In general, employers with at least 100 employees are required under WARN to give affected employees, unions, and local and state governments 60 days advance notice of mass layoffs or plant closings. Some states have statutes with more stringent requirements.
Multinational employers considering a RIF in the European Union (EU) must take into account EU directives that require consultation with labor unions prior to major layoffs and impose other burdens. Requirements in other parts of the world vary. Local counsel should be consulted to ensure that any RIF conforms to local law.
Employee vs. Independent Contractor: Employers that terminate and rehire former employees need to determine whether the individual continues in an employee role or becomes an independent contractor. For federal employment tax purposes, common law rules are utilized in determining whether an employer-employee relationship exists. The key to this determination is to look at the entire relationship and consider the degree or extent of the employer's right to direct and control the employee. Moreover, it is of no consequence that the employee is designated as a partner, agent, independent contractor, or the like. Therefore, it is critical for an employer to determine correctly, based on the entire relationship, whether a former employee who is rehired can be characterized as an independent contractor. The individual's status as an employee v. independent contractor will have an impact on many of the employer's benefits, including whether certain benefits can be provided, and if so, how.
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