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August 1994

Funded severance plans - the new defined-benefit plans.

by Katz, Harvey M.

    Abstract- The appeal of defined-benefit plans has diminished in recent years with the passage of pension laws that have imposed new limitations on compensation and benefits while increasing the funding requirements for financing plan liabilities. Moreover, regulations on coverage and discrimation have been tightened by Congress, making plan administration more costly and cumbersome. As a result, the IRS has introduced regulations intended to persuade existing plans to either redraw their funding provisions or come up with new contracts that allow defined-benefit plans to remain in compliance with pension law. These new pension rules, which have a substantial impact on the plans of small privately-held employers, should therfore be carefully scrutinized to ensure that plans are appropriately designed to meet discrination rules and properly funded to meet financing regulations.

Spurred by client's requests, professionals continue to search (for the most part in vain) for opportunities to fund employee benefits on a tax-deferred basis. The quest has acquired new intensity in light of the expectation that combined federal, state and local income tax rates will rise to approximately 50%. One possibility is a funded severance plan. Similar arrangements had some popularity in the early 1980s when employers were able to fund them through Voluntary Employee Benefit Associations (VEBAs).

The Tax Reform Act of 1984 (TRA '84), eliminated many abuses by sponsors of VEBAs by imposing strict prefunding limitations on employer contributions. Prior to TRA '84, many aggressive programs designed for closely held employers "pushed the envelope" in terms of plan funding and the expansiveness of the definition of a "severance event."

However, in restricting prefunding of welfare benefits, Congress fashioned a limited exemption, IRC Sec. 419A(f)(6) for "10 or more employers plans." The IRC defines a "10 or more employers plan" as: a plan i) to which more than one employer contributes; and ii) to which no employer normally contributes more than 10% of the total contributions of all employers. The IRC further prohibits the use of experience-rated arrangements with respect to individual employers.

Notwithstanding these safeguards, in the years since enactment of the IRC Sec. 419(f)(6) exemption, several aggressive severance programs were marketed in an attempt to bring tax-deductible prefunding to closely held employers. While these programs suffered from some of the same defects as the pre-TRA '84 VEBA arrangements, there is no reason why a sensibly designed, reasonably funded severance arrangement could not qualify under IRC Sec. 419(f)(6).

Plan Design

ERISA's coverage and discrimination rules do not apply to severance plans. Thus, severance plans can discriminate in favor of highly compensated employees (although the plan trustee may insist on token participation by rank and file employees). The controlled group, affiliated severance group and employee leasing rules of IRC Secs. 414 (b), (c), (m), (n), and (o) do not apply. Moreover, stock attribution rules among family members do not extend to severance plans. Aside from a 200% compensation limit on benefits (based on the employee's final year of compensation), there are no maximum benefit limitations. Most importantly, benefits are neither subject to IRC Sec. 415 limitations nor aggregated with their retirement benefits for IRC Sec. 415 purposes. In sum, employees can participate on a selective basis without regard to discrimination or controlled group rules.

Funding, Administration, and Operation

Conceptually, funded severance arrangements operate like defined- benefit plans with one exception: interest rate, turnover and mortality assumptions are established by the plan trustee to minimize the possibility of "cross-employer subsidization." Otherwise, the actuary's role is substantially the same as with a defined-benefit plan: collection and verification of census data, calculation of plan benefits and contributions, and preparation of an actuarial report and Form 5500 (although no Schedule B is required).

Benefit and Payment Flexibility

Severance plans are free from numerous restrictions normally associated with taxqualified plans. There are no minimum distribution requirements, joint and survivor rules, no excise taxes on excess distribution, no limitation on death benefits, and no complicated tax or rollover rules to monitor. All payments must be made within two years of the employee's termination and are taxable as ordinary income.

Definition of Severance Event

The threshold question in designing a sound severance program is the list of events that would trigger severance payments. Critical is the distinction between severance and retirement benefits. While retirement benefits, when vested, are payable upon retirement or termination, regardless of the reason for the employee's separation, severance is payable only upon the occurrence of specific events beyond the employee's control and is forfeited if the employee voluntarily terminates in the absence of a specific event. Nevertheless, the list of severance events that give rise to payments can be far more inclusive than one might initially expect. For example, one particularly well- designed program references the New York State Unemployment Insurance Law definition of events, which would permit award of unemployment insurance benefits. Thus, in addition to the undisputed events (death, termination, disability, and dismissal) severance events can include a class of "voluntary terminations with cause," or in the author's words "induced resignations."

These reasons could include termination because of a dispute between principals of the business, termination because of deterioration of skills (such as with a surgeon), termination because the business is no longer profitable enough to support the employees "earnings," early retirement window programs, or any agreement to permit older, less productive partners or employees to terminate employment, and terminations precipitated by changes in corporate ownership duties, reductions in salary, or changes in location or working conditions. Indeed, an examination of the foregoing laundry list supports the idea that many socalled "voluntary" terminations are "included" and without qualify for payment of severance benefits.

In summary, is appears that an employer could design and contribute to a severance program with reasonable confidence that benefits can be payable to employees in the event of most, but not all, separations from employment.

Controlling Shareholders

Payment of severance benefits to controlling shareholders of the employing corporation presents special concerns. Because many severance events are "induced terminations," it is difficult to maintain the position that the controlling owner of a corporation allows that corporation to force (or even "induce") his or her own termination. To eliminate the possibility for abuse, a well-conceived plan places severe restrictions upon participation by controlling shareholders. For example, such a plan should exclude a 50% or more shareholder (or even a 25% shareholder who cannot be outvoted by four other shareholders) from participation.

Moreover, despite the fact that IRC Sec. 414(b), (c) and (m) controlled group rules do not apply to IRC Sec. 419 plans, a conservatively designed plan will determine ownership and control based upon some notion of common ownership and family attribution concepts. For example, all shares of stock owned by an individual's spouse should be attributed to the individual.

Despite these restrictions most closely held corporations or partnerships could structure a program to prefund severance benefits. Typically, the three-partner medical practice would use the program to fund an early retirement inducement in the form of a "window" program for its most senior doctor. Firms can use similar "window" programs to ensure more orderly progression of younger partners to senior status, if there are sufficient severance inducements for older partners.

Disguised Pension Arrangements

ERISA prohibits employers from using severance plans as a device to pay deferred income to employees without adherence to rules regulating pension arrangements. To be sure, ERISA requires all funded pension arrangements to be nondiscriminatory and broadly defines a pension plan to be "...any plan fund or program...that...i) provides retirement income to employees, or ii) results in deferral of income by employees for periods extending to termination of employment and beyond..."

Against this legislative backdrop, the Department of Labor regulations distinguish severance arrangements from disguised pension plans by limiting the total amount of severance payments to twice the employee's annual compensation during the year immediately preceding the termination and limiting the payment period in most cases to 24 months after termination of employment. Although the severance pay plan limitations restrict the tax deferrals available under the program, it is essential that a well-drafted plan follow these rules.

Funding and Accrual Rules

Sensible funding and accrual rules are an essential element of sound severance plan design. Two concerns must be addressed:

* Plan design issues discussed above are only part of the necessary elements of a valid deduction under IRC Sec. 162 (as "ordinary and necessary" business expense);

* Funding calculations must follow reasonable actuarial principles. A conservatively designed program mandates that full benefits accrue ratably over at least 10 years and structures the employer funding and deductions accordingly.

The use of ratable accruals also helps solve another problem: "cross- employer subsidation." Because a funded severance plan under IRC Sec. 419A(i)(6) must include at least 10 employers and cannot be individually experience-rated, each employer, understandably, will want to minimize subsidies to other employers. Some trustees have designed plan formulas to virtually eliminate "cross-subsidization" by mandating lengthy periods for participation for full benefits to accrue and by restricting benefits available during the initial years of participation.

Operation and Administration

Except for the fact that a multiple-employer trust is involved, administration and actuarial valuation for funded severance arrangements are remarkably similar to those of a defined-benefit plan. Each year the employer's share of the trust's earnings and appreciation is computed and compared to the value of benefits accrued. Noteworthy is the fact that the strictures of Treasury Regulations under IRC Sec. 412 are inapplicable to funded severance arrangements--but should be utilized as guidelines to the extent the Treasury position reflects sound actuarial practice.

Funding Vehicles

While it is technically possible to fund a IRC Sec. 419A(i)(6) plan through a VEBA, there are restrictions that eliminate VEBAs as a practical funding vehicle. Most notably, VEBAs must follow nondiscrimination rules, which prevent a benefit design favoring shareholders and highly compensated employees. In addition, employer compensation for purposes of a VEBA provided benefit is subject to the $200,000 limitation (which is currently indexed at $235,840 but may be reduced to $150,000 if President Clinton's tax proposal is enacted in its current form). Finally, employers participating in a VEBA must meet certain geographic restrictions.

Because the tax status of the funding vehicle does not affect the deductibility of the contributions and given the above noted impediments to a VEBA, a taxable trust is an alternative choice. Taxation of trust earnings can be avoided by funding the trust with tax-free municipals or investment-grade insurance contracts. While not achieving all the deferral benefits of a taxexempt trust, taxable trust is nevertheless an economically viable funding alternative.

Funded severance plans offer certain advantages and suffer from certain disadvantages when compared to tax-qualified retirement plans. In appropriate situations, a carefully designed, conservatively funded severance pay program warrants serious consideration by employers. The comparative advantages and disadvantages of the two programs are summarized in the accompanying table.







































































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