Supplemental Unemployment Benefit Plans Offer Tax Advantages to Employers Seeking to Support Laid-Off Workers

April 10, 2020

Employers considering layoffs in the face of the coronavirus (COVID-19) crisis have additional opportunities to support furloughed workers, aside from options offered by the CARES Act.

The recently enacted Coronavirus Aid, Relief, and Economic Security (CARES) Act  offers employers dramatically affected by the coronavirus (COVID-19) crisis several options to retain their employees, including allowing businesses to delay payment of the employer portion of payroll taxes, up to $5,000 in refundable tax credits, and the Paycheck Protection Program and corresponding loan forgiveness opportunity for small businesses.[1] Even with these programs, some employers are considering layoffs, but would like to provide additional financial support to their laid off employees while such employees are receiving state unemployment benefits. A supplemental unemployment benefits plan allows employers to supplement state unemployment benefits for their laid off workers while saving both the employer and employee share of FICA and FUTA taxes.

Generally, severance payments made by an employer to former employees on account of their separation from service are subject to FICA and FUTA tax. However, in Revenue Ruling 56-249 the Internal Revenue Service (IRS) introduced an administrative exception from FICA and FUTA tax for supplemental unemployment benefits (SUB-Pay) to encourage employers to provide financial assistance to employees in the event of a downsizing. SUB-Pay is pay provided to employees who were involuntarily separated from service and is linked to their receipt of state unemployment benefits. This exception from FICA and FUTA tax, which has no statutory basis in the Internal Revenue Code (the Code) nor the Treasury Regulations, was the result of a combined policy decision of the US Departments of Labor and the Treasury.

Since this initial Revenue Ruling, the IRS expanded the scope of the SUB-Pay exception in subsequent Revenue Rulings. For example, in Revenue Ruling 60-330, the IRS concluded that SUB-Pay does not need to be paid from a trust to be excluded from FICA and FUTA tax. In Revenue Ruling 90-72, the IRS reiterated its conclusion that SUB-Pay must be linked to the receipt of state unemployment benefits to be excepted from FICA and FUTA tax (which had been delinked from state unemployment benefits in Revenue Ruling 77-342) and made clear that SUB-Pay must not be received in a lump-sum. SUB-Pay is, however, subject to federal income tax withholding.

In 2014, in United States v. Quality Stores, Inc., 134 S. Ct. 1395, the US Supreme Court concluded that SUB-Pay as defined in Section 3402(o) of the Code, which does not link SUB-Pay to the receipt of state unemployment benefits, is wages for FICA tax purposes. But, the Court failed to address the validity of the IRS’s position that SUB-Pay linked to state unemployment benefits is not subject to FICA, thus leaving the administrative exception in place.

Based on IRS guidance, SUB-Pay will be exempt from FICA and FUTA tax if the following conditions are met:

  1. The SUB-Pay plan must be in writing
  2. The SUB-Pay plan must be designed to supplement the receipt of state unemployment benefits and must be tied to either the actual receipt of state unemployment benefits, or to the following three situations where the employee is ineligible to receive state unemployment benefits: (a) where the employee does not have sufficient employment to be covered under the state system, (b) where the employee has exhausted the duration of state unemployment benefits, or (c) where the employee has not met the requisite waiting period under state law
  3. The SUB-Pay plan must not disqualify the employee from receiving unemployment benefits
  4. The SUB-Pay must be paid after an employee is involuntarily terminated and only while the employee remains unemployed
  5. The SUB-Pay plan may be funded through a trust, although it is not required to be funded through a trust (most companies do set up trusts)
  6. SUB-Pay cannot be paid in a lump sum (employers that already promised severance pay cannot switch to a SUB-Pay plan and then offer to “cashout” employees)
  7. SUB-Pay may be more than the unemployment benefits that are available under state programs

IRS guidance provides employers with a variety of planning options to pass on the employment tax saving to their furloughed workers. Employers may set up “Offset SUB-Pay plans” that reduce SUB-Pay by the amount of state unemployment benefits or offer SUB-Pay as a flat percentage of the employee’s former pay, with no offset. Notably, IRS guidance does not prohibit employers that have adopted SUB-Pay plans from rehiring furloughed employees at a future date. Thus, adopting a SUB-Pay plan offers employers a unique opportunity to support their furloughed workers through a tax-advantaged vehicle without hindering their ability to rehire the workforce when business resumes. But, given their complexity, it may be advisable to have the plan administered by a third party to avoid losing the FICA and FUTA exemptions.

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If you have any questions about SUB-Pay plans or would like to prepare a SUB-Pay plan or trust, please contact any of the following Morgan Lewis lawyers:

New York
Craig Bitman
Mary (Handy) Hevener

Amy Pocino Kelly
Mims Maynard Zabriskie
David Zelikoff

Washington, DC
Jonathan Zimmerman