Creating an effective pay program is challenging enough. It’s even more so with the emotion that comes into play when a company makes the decision to part ways with an employee. If your company is facing a reduction in force due to new technology, a merger, or another business reason, severed employees won’t be alone in feeling the stress; as a member of the team executing on the reduction, you, too may find the situation challenging.
Severance pay packages, originally intended to provide an income bridge between an old job and a new one, are expensive. And just because the dollars paid are, in effect, leaving the building, it doesn’t mean they are pulled from a completely different pot.
Like active pay, severance pay generally comes from your overall compensation budget. This can ripple into the future, especially if severance wasn’t considered during your compensation budget planning.
Two Common Severance Strategies…And One Not
There are two common options for severance pay. You probably know them. But there is a third strategy you may not know about. Sanctioned by Internal Revenue Code Section 501(c)(17), the Supplemental Unemployment Benefits (SUB) plan can help you control the costs of severance pay while still bridging the gap for severed employees.
Commonly, companies pay severance with a single lump sum payment to affected employees. The payment is usually calculated based on salary and tenure. The payment is taxable, and the full amount is paid out irrespective of when (or if) the former employee finds a new job.
Another strategy is salary continuation for a specified number of weeks. While these payments are also taxable, the company does not need to come up with the full lump sum amount all at once—something that can be particularly difficult when a large number of employees is involved.
This can be helpful from a cash flow standpoint. Similar to the lump sum payment, the length of salary continuation is usually dependent only upon a formula, and has nothing to do with the employee’s landing of a new job. The result can be double pay for those fortunate enough to find a new gig while still receiving pay from you.
Another, Less Expensive Way to Pay Severance
A less common alternative, the SUB plan can substantially reduce the company’s costs and even net the ex-employee more money. Payments under the SUB plan are classified, not as wages, but as benefits.
Because of that distinction the terminated employee doesn’t pay FICA taxes, which are currently 7.65%. The employer is also exempt from employment taxes, including FICA, FUTA and SUTA. Together, these taxes amount to 10.35% of pay—adding significantly to the company’s costs.
A key component of a SUB plan is integration with state unemployment benefits. All 50 states allow companies to tie their SUB plan with unemployment benefits, so that employees receive a portion of the entire weekly benefit from two sources—the SUB plan and the state. When the employee gets a new job, both state unemployment and SUB plan payments cease.
To illustrate, an employee whose weekly pay is $1,200 is entitled to 12 weeks of severance pay, or $14,400 in total. FICA taxes would take $1,102 of that amount, netting the employee $13,299. The company’s cost to provide the severance payment would amount to $15,891: the severance amount of $14,400, plus FICA ($1,102) and FUTA/SUTA ($389).
Contrast those figures with a SUB plan, which first takes into account unemployment benefits. For this illustration, assume the employee is entitled to receive $650 per week in unemployment benefits. The SUB plan will pick up the remaining $550 per week, for a total of $1,200.
The employee here would receive the full $14,400—$7,800 of state unemployment benefits and $6,600 from the SUB plan with no reduction for FICA. No FICA, FUTA or SUTA taxes would be due from the employer, either. Because part of the benefit is being paid by the state unemployment system, the employer cost would be just $6,600.
Administrative Costs, Plan Design Flexibility
You may have noticed the administrative contrast between the options. Doing things the old way means either writing a one-time check or continuing with payroll. With a SUB plan, there will be tracking of state regulations, claims, and employment status for employees. A third-party administrator can handle these tasks. And even considering those costs, a company stands to save substantially by using a SUB plan.
SUB plans can be designed in a variety of ways, as long as they meet the requirements of IRC section 501(c)(17). Among the requirements: there must be a written plan document, the money in the trust must be solely used to provide supplemental unemployment benefits, and the plan must not be discriminatory toward certain employees. There are others, and a qualified expert can help you sort them out.
Plans can be designed with an eye toward saving the company as much money as possible while still bridging the gap for employees, or to provide more generous benefits to the former employee—or somewhere in between.
For example, the plan could include provisions that encourage employees to find new employment sooner than later by paying out a portion of the remaining benefit in the form of a bonus. Or, it might direct savings gleaned from employees whose benefits end early toward employees whose benefits have expired but who have not yet found another job.
If a supplemental unemployment benefits plan appeals to you, you can find a number of experts to help you create one that works in your specific circumstances. Total Management Solutions is at www.subpay.com, and Transition Services, Inc. is at www.transitionservices.com. No matter who you choose to assist, exploring the options may pay off for your employees, and your company.