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November 10, 2006
A recent court decision held that separation payments made to electing employees under a ``forced transfer'' program constituted compensation for services that was subject to employment taxes. The decision by the Court of Federal Claims in CSX Corporation (CSX Corporation, FedCl, 17,769B) highlights the broader issue of the various withholding and employment tax results that may occur depending upon how an employer decides to undertake a reduction in its workforce.
FICA and FUTA taxes
The Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) impose taxes for Social Security, Medicare and unemployment insurance. Employers are required to collect and deposit these taxes from their employees' wages on behalf of the government.
Employee terminations
In general, payments made to an employee by an employer on account of a dismissal that is an involuntary separation are subject to FICA and FUTA taxes, regardless of whether the employer is legally required to make the payments. Voluntary terminations, however, are subject to employment taxes only if the payments are remuneration for past services. If the payments are ``buy-outs'' or payments intended to buy an employee out of his or her right to future employment, the payments are not treated as wages but, rather, as purchases of contract rights and are not subject to FICA or FUTA taxes.
Special SUBs rule
Even if payments would otherwise be treated as dismissal payments or remuneration for past services, they are not treated as wages if they qualify as supplemental unemployment benefits (SUBs). Under IRC 3402(o)(2), SUBs must be benefits paid as a result of an involuntary separation from employment. Payments that are generally treated as remuneration for services or dismissal payments will not be treated as wages for FICA and FUTA tax purposes if they qualify as SUBs.
Several court decisions have examined whether payments for layoffs, reductions in hours and permanent separations of service are SUBs. In general, separation payments qualify for SUB treatment if the payments are elected by employees that are in layoff status. Since the employee is already separated from service, he or she is not considered to have voluntarily separated from employment. If, however, the employee is still an active employee, the separation payments do not qualify as SUBs because the decision to terminate employment is considered to be voluntary.
Latest example
In the latest case dealing with SUBs, the Federal Claims Court examined if certain payments made from an employer to its employees as part of a ``forced transfer program'' were SUB payments. The forced transfer agreement allowed employees on furlough status to choose to transfer to a different location or to separate from service and receive a separation allowance.
The court decided that the payments did not qualify as SUBs and were subject to employment tax. The court reasoned that because the employees had the choice to remain employed, the ones who chose to separate did so voluntarily, even if it was at the price of disrupting their personal lives by moving to a new area. As a result, the payments were subject to FICA taxes as well as to Railroad Retirement Tax Act (RRTA) taxes, which are special employment taxes imposed only on railroad employees.
Structuring terminations
Employers that want to avoid paying employment taxes may consider structuring their agreements in such a way that payments made under them qualify as SUBs. To that end, incorporating certain ``SUB'' elements into structuring a separation-from-service plan can help.
Many SUB plans are structured by setting up a trust fund into which a cents-per-hour contribution is made that covers all employees. Employees who have been laid off and meet the state unemployment benefit eligibility requirements are entitled to weekly cash benefits from the trust in addition to the state benefits. A plan that includes the following elements will likely be treated as a SUB plan:
Benefits are paid only to unemployed former employees of the employer who are on layoff;
Eligibility for benefits depends on the meeting of set conditions subsequent to the termination of the employment relationship with the employer;
Benefits are paid by the trustees of independent trust funds;
The amount of weekly benefits payable under the plan is based on (a) the amount of weekly benefits payable under the appropriate state unemployment compensation laws, (b) the amount of other remuneration allowable under such state unemployment compensation laws, and (c) the amount of straight-time weekly pay after withholding of all taxes and contributions;
The duration of weekly benefits payable under the plan depends upon a combination of the number of accumulated credited units and the fund position;
A right to a benefit does not accrue until a prescribed time after the termination of the employment relationship has elapsed;
The benefits paid are not attributable to the rendering of a particular service by the recipient during the employment period; and
No employee has any right to any of the assets in the fund or to any employer contributions until that employee is qualified and eligible to receive a benefit.
If an employer plans to make payments as a purchase of contract rights, the existence of several elements may be helpful to support the claim that the payments are indeed for the purchase of a contract. For example, if the contract is for a specified period that has yet to run, the contract itself does not specify payments for early termination and the amount of payment is not conditioned on length of service or amount of pay, the employee will be able to make a good argument that the payments are for the purchase of his or her contract rights and not wages.
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