Q & A: Severance Pay for Nonprofit Employees

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Nonprofit organizations may legally provide severance pay.   But under what circumstances, and how much?  How do unemployment benefits fit with severance?  And why put it in writing?  Whenever a nonprofit employer considers whether to provide severance pay to a terminated employee, many significant questions can arise warranting careful evaluation of several factors including risk management, stewardship, fairness, and practical business decisions. 

1.  When Should an Organization Consider Providing Severance Pay?

Severance pay may be appropriate if an employee is laid off, terminated with or without “cause,” or resigns from employment.  Employment termination can result from a variety of circumstances, some of which may involve contentious people and very challenging issues.  Severance pay thus may be an appropriate risk management tool for avoiding potential litigation, adverse publicity, and other claims against the nonprofit employer. 

Preliminary considerations include the following.  First, nonprofit organizations should scrupulously avoid any communications, such as in employee handbook provisions, that would lead employees to reasonably expect severance pay upon termination. Second, nonprofit employers should be careful about consistency among employees, to avoid later claims of inequity and even unlawful discrimination among differently treated employees.  Third, severance pay should not be presented or perceived as a “bribe,” since numerous legitimate considerations may favor its provision under certain circumstances.           

In addition, a nonprofit organization should take into account whether unemployment insurance benefits will be available or not to the discharged employee.  Significantly, no unemployment benefits will be available to employees of churches, church-controlled organizations (e.g., religious schools), and smaller nonprofits (i.e., less than 4 total employees within at least 20 calendar weeks of the current or preceding year).  The only exception is if the nonprofit employer has voluntarily elected to participate in the government unemployment system, which is extremely rare.  The nonprofit employer’s lack of coverage, alone, may provide a compelling justification for severance pay.

2.  May Severance Pay Be Legally Provided?

a.  Tax Prohibitions

As an initial matter, no payments – whether severance or otherwise – may be provided that constitute an improper private benefit.  Tax-exempt public charities are legally prohibited from allowing both insiders and persons outside their organizations to receive financial benefits from the organization’s resources, except through either (1) a quid pro quo arrangement (e.g., reasonable wages paid for work performed); or (2) other payments in furtherance of the organization’s tax-exempt purposes, such as benevolence for religious organizations or grant-making and scholarships for charities.  When insiders improperly benefit, this is known as “inurement” and is illegal.           

b.  Not a Gift, Benevolence, or Other Assistance

Some have argued to the IRS that severance payments amount to legitimate non-taxable income because they constitute gifts.  However, the term “gift,” at least in tax parlance, means something given “from a detached and disinterested generosity . . . out of affection, respect, admiration, charity or like impulses,” with the key consideration being the transferor’s intent.  (See Commissioner v. Duberstein, 363 U.S. 278 (1960)).  If an organization is paying an employee in recognition for his or her prior service, then by definition such payment does not amount to a “gift” and therefore constitutes taxable income to the individual. 

More significantly for the organization, if it pays any employee a “gift,” then the critical question arises of whether this payment is an improper use of the organization’s assets.  An IRS finding that the payment is improper could jeopardize the organization’s tax-exempt status, therefore making this an extremely serious issue.   The recommended (albeit more conservative) approach here is to never categorize severance pay as a “gift.”

Similarly, severance pay should never be categorized as “benevolence” or other charitable assistance.  Like a purported “gift” to a departing employee, this treatment raises significant tax issues regarding the propriety of the organization’s payment.  Although it is well recognized that religious and charitable organizations may provide benevolence and other assistance (e.g., grants), the IRS likely would classify such a payment as taxable compensation that is directly related to the employee’s prior services as an employee.

c.  Quid Pro Quo Payments or Other Legitimate Purposes 

Generally speaking, a nonprofit employee may receive severance pay as a quid pro quo arrangement – i.e., something paid in return for the employee’s prior work for the organization.  In addition, severance pay may otherwise be appropriate for legitimate business purposes.  Such arrangements are common within the for-profit sector for a variety of reasons, and the business rationales for such payments may apply equally for public charities. 

The operative question for a nonprofit, in light of its privileged tax-exempt status, is whether the severance pay is an objectively reasonable use of its charitable assets.  The answer will depend on a due diligence evaluation of factors as set forth below. In addition, nonprofit employers should be continually mindful of their own available financial resources and other stewardship responsibilities.          

3.  Should Severance Pay Be Provided as a Legitimate Business Expense?

a.  Practical and Legal Analysis

The due diligence inquiry should help lead the organization’s governing body to a determination of whether severance pay is a justifiable and appropriate expense and, if so, how much severance pay should be provided.  Two examples may help to flesh out whether and when severance pay is appropriate.

One simple scenario is an executive director who faithfully serves a ministry for many years but decides to leave the organization for personal reasons.  The organization may legitimately provide a severance package based on his or her years of service.  One or two weeks of severance pay per year of work may be deemed appropriate depending on the employee’s prior dedication and service to the ministry, his or her personal circumstances, the ministry’s financial wherewithal, other available financial resources for the employee such as retirement benefits, and available information about comparable employment practices within similar organizations.

Another scenario, which may be problematic and unfortunately all too common, is an organization that experiences significant trouble with a key leader.  Donors, board members, or others may be dissatisfied and want this person to leave.  He or she may have engaged in offensive behavior, not led the organization as its other leaders had wanted, or otherwise not measured up to expectations.  In that case, the analysis may need to be focused more on the extent to which a severance pay arrangement will buy  “peace of mind” for the organization.  In other words, it may be prudent and worthwhile to pay the employee some amount of money in order to eliminate the risk of future claims or other problems stemming from termination.

The analysis of whether to provide severance pay should include the following considerations:

(1)       The circumstances of the termination and whether it is likely the terminated employee will later cause problems for the organization through making disparaging statements about the organization, disclosing confidential information, or damaging property;

(2)       Whether the employee’s cooperation will be needed in the future, such as to maintain confidentiality, communicate positively with donors, surrender passwords, or complete a long-term project;

(3)       Whether any valuable personal property needs to be returned by the employee, such as a computer;

(4)       The likelihood of whether the employee would later assert contract, tort, or other claims against the organization, such as for unpaid compensation or defamation;

(5)       Whether the employee falls within one or more legally protected classifications such as age (over 40), race, national origin, disability, or religion, and for which he or she may try to assert a claim; and

(6)       Whether the possibility of a retaliation claim may exist under discrimination, whistleblower, or other work-related laws, for which the employee may try to assert a claim.

Any or all of these reasons, as well as other reasons, may justify providing a severance package to a terminated employee, in exchange for an express waiver of claims and an agreement to cooperate with the organization in various matters.  Lawsuits – even ones that are ultimately defeated – cost money to defend, can cause much negative publicity, and can easily distract a nonprofit’s leaders from their mission.  Properly structured severance pay agreements thus can bring many tangible and valuable benefits to a nonprofit organization, making them appropriate and justifiable.

A severance package may likewise be very attractive to a terminated employee.  The prospect of severance pay may be a helpful “carrot” to encourage his or her future cooperation.  In addition to providing for severance pay, the agreement could include benefits such as mutual non-disparagement between the employee and the organization, a neutral or positive job reference, and perhaps continued health benefits. 

b.  Unemployment Insurance Benefits

Nonprofits should consider severance pay in conjunction with unemployment insurance benefits, to the extent available.  Notably, a severance pay agreement cannot legally provide that an employee waives his or her right to government-provided unemployment benefits.  Accordingly, nonprofit employers should consider the following points.

First, the overarching purpose of unemployment insurance benefits is to provide a safety net to unemployed persons who have not voluntarily resigned or been discharged for serious misconduct.  Accordingly, benefits will generally be awarded to persons who are laid off, discharged for negligence or incompetence, or otherwise terminated from employment without clear proof of wrongdoing. 

Second, unemployed persons do not have an unconditional right to continued unemployment insurance benefits.  Benefits terminate upon re-employment or full-time student enrollment, and claimants must actively seek work while unemployed.  

Third, unemployment benefits are limited in duration and amount.  Typically, they can last up to thirteen weeks, but potentially up to twenty-six weeks if statewide unemployment rates are elevated. The amount of unemployment benefits is slightly less than half of an employee’s former earnings, and they are subject to a significant rate cap based on average wage earnings within the work force.

4.  How Much Severance Pay Should be Paid?

No bright line rule exists for determining how much severance pay to provide.  The main concern should always be proper stewardship of the nonprofit’s financial assets in furtherance of its tax-exempt purposes.  If a long-term employee is leaving, it may be a very appropriate quid pro quo payment to provide generous severance.  If a contentious employee leaves, the organizational leaders may feel forced to provide extensive severance as a risk management decision.  Generally, provision of a few weeks to a few months of severance pay should be deemed reasonable under many circumstances.  In contrast, a year’s worth of severance pay would be viewed as highly unusual and therefore would warrant extensive due diligence and substantiation to justify such a large severance package.

5.  How Should Severance Pay Be Provided?

a.  No Prior Expectation

Nonprofit employers should never indicate orally or in writing that severance pay may be expected by its employees upon termination.  Instead, each severance pay decision should depend on a variety of reasons including the employer’s length of employment, the reason(s) for termination, risk management considerations such as the likelihood of later litigation or bad publicity, and the organization’s financial condition at the time of termination.

On the other hand, it is appropriate that non-covered nonprofit employers (i.e., churches, church-controlled schools, and very small nonprofits) disclose in writing (and orally as appropriate) that employees will not be entitled to unemployment insurance benefits upon termination.  Such disclosure helps prevent unpleasant surprises later that can be awkward for the employer’s leaders and very traumatic for the employee.  Prior disclosure also should help prudent employees plan accordingly for potential future unemployment.  The disclosure should be included in the employer’s employee handbook or other prominent employment materials.

b.  Put It In Writing!

Severance pay should always be put in a written agreement, with assistance of legal counsel.  The following key terms should be included in the agreement:

(1)       Correct identification of the parties;

(2)       Specific severance amounts to be paid according to a time table for paying installments, subject to applicable employment tax deductions and the employee’s continued compliance with the agreement;

(3)       Confirmation that all earned compensation has been paid, including paid leave such as vacation;

(4)       Express waiver of the employee’s potential discrimination, contract, wage, and tort claims against the organization and its directors, volunteers, employees, and other agents, at all times through the date of the agreement;

(5)       Confidentiality of the agreement’s terms;

(6)       Acknowledgment that the employee has been notified of his or her rights to continued health insurance under COBRA or state law; and

(7)       Twenty-one day period to consider agreement (which may be waived) and seven-day revocation period after execution (which may not be waived), for terminated employees over forty years old.

The waiver of claims provision should be a critical precondition to payment of any severance pay.  The nonprofit employer’s severance payments should never be allowed to fund an employee’s subsequent lawsuit against it.  In addition, severance should be paid in separate installments over time, and not in a lump sum.  For the organization’s cash flow, installment payments may be very helpful.  For the terminated employee, this safeguard should help promote his or her continued compliance with the agreement, including maintenance of the agreement’s confidentiality and cooperation regarding other aspects of the agreement. 

Terminating employees is never an easy task, and severance pay may be appropriate only occasionally.  By thinking through the above questions and responsive guidance, nonprofit leaders can be well equipped to develop wise and thoughtful severance agreements for both their organization’s and former employees’ well-being.