INSIGHT: SUB-Pay Plans—An Alternative to Severance Programs

April 6, 2020, 1:00 PM

Restructuring a temporary or permanent layoff program as a financially attractive severance alternative known as “supplemental unemployment benefit plans” or “SUB-pay plans” can yield financial and tax savings exceeding 30% of an employer’s typical severance costs while also providing FICA tax savings to employees of 7.65%. Such plans can be self-administered while navigating and responding to the financial, operational, and human costs raised by the coronavirus. While some advisers adopt the SUCB-pay acronym, this article uses SUB-pay throughout based upon the author’s role within the IRS National Office while assigned technical responsibility over SUB-pay plans.


Severance plans have historically disqualified many employees from receiving state unemployment benefits. By contrast, SUB-pay plans are designed to supplement, integrate, or, as the IRS states, “link” with state unemployment benefits. The strength of those design features or links with state unemployment have vacillated over the years. Although SUB-pay plans were almost eliminated by the IRS in the early 1990s, traditional SUB-pay plans have a renewed platform as a result of the Supreme Court’s decision in Quality Stores. Whether they will exist in five or 10 years will depend on further swings of the pendulum.

Financial Savings

The financial savings associated with a SUB-pay plan vary depending on the plan’s structure, with one of the most significant variations focusing on whether the plan is an “offset benefit” or “full benefit” plan.

Severance arrangements are typically structured as installment or lump sum payments computed as 100% of a laid-off worker’s gross payroll within a given period. By contrast, an offset SUB-pay plan is designed and operated to pay a reduced percentage of gross pay. However, when added to the state unemployment benefits the terminated employee is eligible to now receive, those aggregate amounts will typically approximate 100% of gross wages. The intent is for the employee to receive a termination benefit of approximately 100% of gross payroll wages, but the employer’s funding is offset by the state’s payment of the unemployment benefits.

The amount of the burden shifted to the unemployment system will vary, but it can exceed 30% depending on variables such as the state, the employee’s pay scale, and the employee’s employment service. With extended unemployment benefits in force, an offset plan can offer even greater financial savings to employers.

Tax Savings

A properly drafted SUB-pay plan offers tax savings regardless of whether it is an offset or a full-pay plan. Significantly, the tax savings exist at both the employer and the employee level. In particular, the tax savings come in the form of reduced employer and employee FICA taxes which in the aggregate are typically 15.3% of the amount paid.

‘Wages’ for FUTA and FICA Purposes

The term “wages” for FUTA and FICA tax purposes means “all remuneration from employment” subject to certain statutory and, to a far lesser extent, administrative exclusions. Although more than 20 statutory wage exclusions exist for these Subtitle C provisions, none of the statutory exclusions references or has ever referenced SUB-pay. Since a statutory exclusion did not exist, the collective negotiations resulted in the IRS adopted new administrative positions and interpretations. Initially released as revenue rulings, the new form of benefit structure known as supplemental unemployment benefits paid benefits that were exempt from the definition of taxable “wages” which all of the negotiating parties agreed accomplished the state law objectives to not disqualify the recipients from receiving state unemployment benefits.

Rulings Implications

IRS revenue rulings exempt SUB-pay plan payments from wages for FICA, FUTA, and FITW purposes. The aggregate employer and employee FICA tax savings can exceed $20,000 per year per employee which is why so many tax advisers and third-party administrators focus on the generous tax savings offered by SUB-pay plans.

Drafting and Administering

While various statutory and case law developments impact SUB-pay structure, the primary drafting consideration of a properly structured SUB-pay plan should focus on various IRS published revenue rulings. This is especially true after the Federal Circuit’s decision in CSX Corp. v. United States and the Supreme Court’s decision in Quality Stores.

CSX Corporation. The Federal Circuit struggled with SUB-pay design when analyzing the relevance of tax code Section 3402(o)’s SUB-pay definition. Recognizing that SUB-pay plan design was nuanced and observing that “the correct resolution of the issue is far from obvious” the Federal Circuit rejected the statutory approach and instead adopted a facts-and-circumstances approach based upon the IRS’s administrative rulings.

Quality Stores. The U.S. Supreme Court reversed the Sixth Circuit and held that severance payments structured to satisfy the category of SUB-pay benefits defined by Section 3402(o) constitute taxable FICA wages due to the broad nature of the definition of “wages” for FICA tax purposes. Although the Supreme Court questioned and exposed the vulnerability of the IRS’s administrative approach to SUB-pay, the Court did not overturn the administrative SUB-pay wage exemption.

Revenue Ruling 56-249

Rev. Rul. 56-249 is generally considered the most relevant of the IRS’s early rulings. Rev. Rul. 56-249 identified a broad exception under existing legal principles from the definition of “wages” for FICA, FUTA, and FITW purposes for payments made upon the involuntary separation of an employee from the service of the employer. The ruling summarized eight required plan features:

  • Benefits were paid only to unemployed former employees who were involuntarily laid off

  • Eligibility for benefits depended upon meeting prescribed conditions after terminating employment

  • Benefits were paid by trustees of independent trusts

  • The amount of weekly benefits payable was based upon state unemployment benefits, other compensation allowable under state laws, and the amount of straight-time weekly pay

  • The duration of the benefits was affected by the fund level and the employee’s seniority

  • The right to benefits did not accrue until a prescribed period after termination of employment, i.e., a waiting period prior to commencement of benefits

  • The benefits were not attributable to the rendering of particular services

  • No employee had any right, title, or interest in the trust fund until such employee was qualified and eligible to receive the trust fund benefits

The ruling did not assign weight to any specific factor, that weight has been assigned to various factors and has fluctuated over the decades.

Revenue Ruling 90-72

Rev. Rul. 90-72 continues to recognize a wage exclusion for SUB-pay, however, it rejects the statutory definitions in Sections 501(c)(17) and 3402(o), choosing instead to rely solely on the IRS’s own administrative definition. Note, although still retaining some, albeit reduced, relevance to the FICA exclusion and state unemployment linkage, the relevance, meaning and effect of these two statutory definitions are beyond the scope of this article post-Quality Stores.

Under Rev. Rul. 90-72, the payments must be made to involuntarily terminated employees, the payments must not be in the form of a lump sum, and there must be a “link” between the plan benefits and state unemployment compensation. The ruling does not revoke or modify Rev. Rul. 56-249. Rev. Rul. 56-249 remains a valid, if not the presumptive, interpretation from the IRS’s perspective.

Intervening Rulings

The IRS issued a number of relevant revenue rulings and private letter rulings between these two important IRS revenue rulings. Even though some of the rulings expand what constitutes a SUB-pay plan and have not been subsequently modified by the IRS, many of those rulings have essentially been invalidated by Rev. Rul. 90-72 and subsequent case law.

Tax Code Amendments

Congress enacted two important statutes that still impact plan design and operations:

Section 501(c)(17). This income tax exemption provision formally recognizes SUB-pay trusts. Although not a Subtitle C provision, this Code section has practical implications on the design, operation, and administration of the SUB-pay plan even after the Supreme Court’s decision in Quality Stores.

Section 3402(o). When the IRS recognized the administrative wage exclusion, it originally also provided an exclusion from FITW even though SUB-pay benefits have always been subject to federal income taxes, compare Section 501(c)(17). The FITW exclusion for SUB-pay necessarily created significant administrative issues as the IRS assessed many laid off employees for unpaid income taxes due on the SUB-pay benefits. To avoid such future IRS assessment on unsuspecting workers, Section 3402(o) ensures that the proper withholdings occur.

This article does not discuss the IRS’s internal processes or various revenue rulings that were modified to conform to the statutory definition of “supplemental unemployment compensation benefits” found in Section 501(c)(17) and Section 3402(o). Nevertheless, these two separate statutes still have relevance in the design, documentation, and administration of SUB-pay plans. Unfortunately, most advisers and plan administrators do not address or consider the relevance of such positions.

A third statute was enacted involving FUTA and extended unemployment. However, the better position post-Quality Stores is that this provision does not impact SUB-pay plan operation or design.

Practical Considerations

As employers and tax advisers address coronavirus-related downsizings, it is absolutely clear that SUB-pay plans remain a viable employment, financial, and tax planning tool that employers should consider as they face difficult labor and financial decisions. While the manner in which SUB-pay plans are drafted and operated has changed significantly over the past decade, SUB-pay plans remain a viable and important method to structure reductions in force while realizing financial and tax savings that can dwarf those offered by traditional severance arrangements.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

David Fuller is counsel at McDermott Will & Emery in Washington.

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