Bench & Bar of Minnesota is the official publication of the Minnesota State Bar Association.

The Dough Boy’s Devise: Severance Takes a Poke

New developments—both in the economy and the law—have brought about changes in severance packages given by employers to employees.

Severance arrangements in which employers provide compensation to departing employees, along with other terms and conditions, have deep Minnesota roots. But rulings of the 8th Circuit Court of Appeals1 have dealt setbacks to employees who have entered into severance arrangements with their employers. These decisions were sandwiched around a pair of rulings of the Minnesota Court of Appeals2 that turned out more favorably for separated employees seeking unemployment compensation benefits. Meanwhile, the United States Supreme Court is pondering another severance-related lawsuit.3 Collectively, these cases, along with other developments, illustrate the poking and kneading that employers and employees in Minnesota have experienced recently in proofing their severance arrangements.

Pillsbury Plan

The concept of employers paying employees upon termination of employment, usually coupled with releases and other clauses, was not invented in Minnesota. But the modern form of severance owes much to this state because of a device developed by a well-known, but no longer existing Minnesota business.

In the early 1980s, executives at the Pillsbury Company in downtown Minneapolis developed a plan in response to massive employment lay-offs that occurred at that time. As the economy stumbled and employees were given pink slips, Pillsbury gave the separated employees compensation tied to the length of their service. The formula, in which the amount of severance is related to the years of service, became known as the “Pillsbury Plan,” named after the progenitors of the famous Dough Boy, which was later acquired by General Mills.

Notwithstanding the assimilation into General Mills, the Dough Boy continues to live on, as do severance arrangements providing dough for departing employees. The typical arrangement consists of payment to employees who are separated from employment involuntarily, either due to an economically induced lay-off or, in some instances, for poor performance or misbehavior. In some cases, resigning employees may obtain severance packages, usually through a negotiation process. The core of a severance arrangement usually consists of compensation, whether keyed to length of service, as in the Pillsbury Plan, or on a more flexible basis. The arrangements usually include other terms, some favorable to employers, such as release of claims; others favorable to employees, such as reference letters; and others beneficial to both employers and employees, with confidentiality and mutual nondisparagement, among other features.

Taxation Topics

Whether under a “Pillsbury Plan” grid or otherwise, severance has plummeted in recent years. One wag has remarked that, since the financial crisis of 2007, severance amounts have gone down like house prices. While the housing market has picked up a bit, severance has not. Sizeable severance packages that once equated to a month, or more, of severance for each year of work, have often declined to a more moderate payout of a week, or less, per year of service.

Severance in more contested negotiations not connected to a formula grid also has experienced substantial reductions. The declines are not due solely to economic conditions, but also are related to changes in the legal environment that generally have made it more difficult for “employees to pursue legal claims.”4 But that could be changing, too, at least in Minnesota, where the revitalization of the state whistleblower law, Minn. Stat. §181.932 may lead to larger severance packages to resolve potential legal claims.

The amount of severance varies dependent upon a number of factors. They may include the length of an employee’s service, the financial condition of the business, the reason for the separation from employment, the past practices and precedents of the business, and the strength of the employee’s potential or actual legal claims, among other conditions.

Severance payments can be made in a lump sum, or on a periodic basis, often consisting of a salary continuation for a particular period of time. There are advantages and disadvantages to both features, but in either case, the payments are generally subject to income tax, whether through withholding or self-payments by employees. Some severance payments were nontaxable prior to the amendment of the Internal Revenue Code in 1996, which made most severance payments taxable to employees.

Taxation may be limited, or avoided, in other circumstances. To the extent that severance payments are linked to release of claims, they may be nontaxable, in whole or in part, depending upon the nature of the underlying claims. Claims for a physical injury are nontaxable under §104a(2) of the Internal Revenue Code. Therefore, ascribing a portion of severance to a physical injury can make the payment nontaxable. In other circumstances, taxes might be withheld, but employers and employees can avoid FICA withholding by ascribing a portion of the payment to release of other claims, even if they involve nonphysical injuries.

A tax deduction also may be available for attorney’s fees incurred in connection with legal advice regarding taxation matters. Under §212 of the Internal Revenue Code, an individual may deduct fees paid for such legal advice which may be given in connection with severance-related matters.

Another way to ease the employee’s tax burden is to ascribe severance payments to claims for discrimination under federal, state, or local laws. Under §62 of the Code, attorney’s fees incurred in connection with such claims are tax-deductible. Therefore, through deft negotiations and drafting, a portion of severance payments may be ascribed to attorney’s fees for discrimination claims, if feasible, resulting in a tax deduction for employees. To the extent this benefit is available, employers may benefit, too, by having to pay less severance because the gross amount recovered by the employee may be greater due to exemption from tax or tax deductibility. These features should be taken into account in negotiating severance agreements.

The United States Supreme Court also is weighing in on severance. In U.S. v. Quality Stores, Inc., No. 12-1408, it is considering whether severance payments paid to laid-off employees may be subject to FICA income tax withholding. The justices heard oral arguments earlier this year on an appeal by the Internal Revenue Service from a decision of the 6th Circuit,5 holding that such payments fall within an exclusion from taxability under 26 U.S.C. §3407(a).

The statute exempts “supplemental unemployment compensation benefits” defined as amounts paid pursuant to an employer plan for reduction-in-force, plant closing, or “other similar conditions.” The outcome of the case could have significant impact on payments made to employees in mass severance situations. If affirmed, the ruling could result in greater net severances for employees.

Pair of Perils

A pair of significant severance decisions of the 8th Circuit, one late in 2013 and one earlier in that year, reflect the perils of violating terms of severance agreements: deprivation of benefits of employees who breach their obligations under these arrangements. In both cases, employees who engaged in post-employment wrongdoing after the agreements were negotiated and executed lost their rights to severance payments.

The property manager for a commercial facility was denied severance because he failed to comply with his obligation under a severance agreement in St. Louis Produce Market v. Hughes, 753 F.3d 829 (8th Cir. 2013). Decided late last year, the case involved an employee who received a severance agreement calling for a lump-sum payment equivalent to 14 weeks of pay. Unknown to the employer, he and his attorney unilaterally changed that to 104 weeks, constituting two years of pay per year, and presented it to the head of the company, who signed it without knowing that the amount had been changed. The severance agreement contained a clause requiring the employee to “return” all company property, as an express “condition precedent” to the company’s obligation to make the severance payment. The employee sued to enforce the severance agreement after the employer refused to pay. The trial court dismissed the lawsuit on two grounds: The failure by the employee to return company property, including a lap top, as required by the severance agreement, as well as multiple discovery abuses by the employee, prompted the judge to strike the pleadings as a discovery sanction under Rule 37 of the Rules of Civil Procedure.

The 8th Circuit affirmed on both grounds. Notwithstanding the dispute over the amount of severance, whether 14 weeks or 104 weeks, the employee was not entitled to any amount because of these two transgressions.

The failure to return the property constituted breach of the agreement, which was an “explicit” condition precedent to the [company’s] obligation to pay him under the agreement. Because of the employee’s failure, the company “had no duty to perform under the agreement … [and] was entitled to judgment.”

Alternatively, the trial court did not “abuse” its discretion in striking the pleadings due to the discovery disputes, which consisted of several “willful” discovery violations during the course of the litigation. So, the employee got to keep his lap top, which he never returned anyway, but nothing else.

Post-employment wrongdoing also was at the heart of another severance case decided earlier in the year by the 8th Circuit. In Hallmark Cards, Inc., v. Murley, 703 F.3d 456 (8th Cir. 2013), the vice president of marketing for Hallmark Cards received a $735,000 severance payment upon leaving the company, coupled with an agreement that she would maintain confidentiality of certain proprietary data. She then began working as a consultant for a competitor, for which she was paid $125,000, while revealing certain confidential data to the competitor in violation of the terms of the severance agreement. Hallmark sued and obtained a jury verdict of $860,000, comprising a refund of the $735,000 severance payment and an additional $125,000 for the consulting fees.

The employer was aided by an instruction the trial judge gave to the jury that allowed it to draw an “adverse inference” that certain emails that the employee had destroyed were incriminating.

On appeal, the 8th Circuit affirmed, although it found that the trial judge erred in giving the adverse instruction without an explicit finding of bad faith and prejudice. Addressing the instruction issue as one of “first impressions,” the court ruled that the trial judge must make explicit determinations of both “bad faith” and “prejudice” in order to justify an adverse inference instruction to a jury based on spoliation. In this case, however, the error was innocuous because there was “overwhelming evidence of bad faith and prejudice” in the destruction of critical documents.

While upholding the instruction, the court slightly trimmed the verdict by deleting the $125,000 segment attributable to the consulting fees. Hallmark was entitled to a refund of the severance payment because of the material breach of the confidentiality clause, but the $125,000 that the employee received for a subsequent consultancy should not have been awarded because it would place the company “in a better position than it would find itself had [the plaintiff] not breached the agreement.” Accordingly, the verdict was upheld, but reduced to require the employee only to pay back the severance payment, and not the consulting fee she earned after leaving the company.

This pair of cases reflects the perils that employees face in not complying with the terms of severance agreements. Employers who detect noncompliance before severance is paid can withhold payment and force the employee’s hand in litigating the issue of breach and materiality, as occurred in the Hughes case. Or, if payment has already been made, the employer can pursue claims against the former employee to recoup the severance payment due to a substantial breach as in the Murley case.

Unemployment Undertakings

The 8th Circuit’s Minnesota counterpart, the state court of appeals, addressed a pair of severance-related disputes in connection with unemployment undertakings by jobless employees, coming between the two federal severance rulings. In both cases, the issue was the extent to which a post-termination payment constitutes a set-off from unemployment compensation benefits. In these cases, unlike the federal ones, the employees fared much better.

Ordinarily, post-termination compensation, as customarily occurs in a severance arrangement, results in a set-off, or delay, of eligibility for unemployment compensation benefits in Minnesota for the length of time attributable to the payments. This deferral does not occur in many other jurisdictions, which allow an unemployment claimant to receive benefits notwithstanding receipt of severance payments.  But the grounds for ineligibility were narrowed by a pair of appellate court decisions last year.

In Moore v. Waterstone Capital Management, L.P.¸ 2013 WL 4504433 (Minn. App. 2013) (unpublished), an employee of a financial management firm in Plymouth received nearly $600,000 in deferred bonus payments for the previous two years, along with an additional payment of $100,000 accompanied by a release of claims. An unemployment law judge (ULJ) with the Department of Employment & Economic Development (DEED), which oversees the unemployment compensation system in Minnesota, held that the employee was required to defer unemployment compensation until all of those payments were ascribed to his regular salary, which would take nearly four years.

The employee appealed, claiming that the setoff, or delay, was improper under Minn. Stat. §268.085, subd. 3, which makes an employee ineligible for unemployment benefits for any period that he has received “severance” pay, bonus pay, and any other payments … .” The appellate court agreed, in part, with the employee. The bonus payments, denominated as deferred compensation, fell within the deferral provision because the “plain language of the statute” treats that deferred compensation as compensable bonus for statutory purposes.

However, the $100,000 paid in consideration for release of claims was not subject to the set-off provision. The court ruled the settlement payment “does not fit” the definition of “wages” under the statute, which includes “all compensation for services, including commissions; bonuses; awards; and prizes; severance payments; standby pay; vacation and holiday pay; back pay; tips and gratuities … sickness and accident disability payments;” and cash value of various payments in kind.6

The settlement payment did not constitute a “severance payment” because it “was in no way correlated to [the employee’s] length of employment.” Further, it was described as an “additional” consideration for signing releases and was “not compensation for [the employee’s services] because it was admittedly for his future actions. Because the settlement payment did not constitute a “severance payment” or other “wages,” it was not subject to the unemployment setoff provision.

Similar treatment was accorded another Minnesota employee who was offered a six-week severance package when his job was terminated, but rejected the offer and continued negotiating for a greater sum while receiving unemployment compensation benefits. In Van De Werken v. Bell & Howell, LLC, 834 N.W.2d 220 (Minn. App. 2013), the employee ultimately received eight weeks’ severance, but a ULJ determined he should have been ineligible to receive unemployment compensation benefits during the interim between being offered the six-week severance and his later agreement to an eight-week severance package.

The appellate court disagreed, holding that the employee was not ineligible for unemployment benefits during this time period since he would not start receiving severance until later in that year. Ineligibility for unemployment benefits due to receipt of severance pay, said the court, “is more appropriately applied to the time period during which the applicant is actually receiving the payments.”

The ULJ’s reasoning that the employee was ineligible to receive benefits following separation of employment, even before he started receiving severance was untenable because it “would force employees to accept any severance pay offered that would be paid immediately or risk having no income even though they are otherwise entitled to unemployment benefits.” It also would unfairly “encourage employers to offer less attractive severance packages upon termination.” Because unemployment laws must be construed in a “remedial” way, an employee is entitled to receive unemployment benefits, without set-off or delay, prior to receipt of severance, and the severance is not then applied retrospectively to delay eligibility. Thus, a claimant can receive unemployment benefits prior to receiving severance, and then further benefits are deferred during the time severance is paid.

The rationale of these two cases was exemplified in another appellate court ruling at the end of 2013 in Ziemer v. Gov. Delivery, Inc., 2013 WL 6725782 (Minn. App. 2013)(unpublished). The court, two days before Christmas, handed a proverbial lump of coal to a terminated technical operations manager at a St. Paul facility, who received unemployment benefits for 14 weeks before she entered into a separation agreement and release that included about $30,000, equivalent to 14 weeks of pay, treated as W-2 income; emotional distress damages treated as 1099 nonwithholding income, and attorney’s fees.

A ULJ determined that the payment established severance and “wages,” which made the claimant ineligible for unemployment benefits she had received and she owed $4,776 for overpayment.

The appellate court affirmed the ruling, even though the ULJ erred in characterizing the payment as “severance.” But the ULJ’s decision properly concluded that part of the payment constituted “back pay,” which defers unemployment benefits. Because part of the payment “was treated as W-2 income and subject to payroll tax and deductions, … the amount was compensation for lost wages and therefore, deductible from [unemployment] benefits.” The employee’s claim that the payment represented “front pay” was not supported by the record, which although “sparse,” reflected that the payment was “compensation or back pay.” Therefore, to prevent a “double recovery” from severance and unemployment compensation, the claimant had to reimburse the unemployment benefits she had received.

These recent Minnesota unemployment cases suggest that employees should strive to phrase their severance agreements as settlement in consideration of release of claims and should try to include language indicating that this payment is not linked to past years of service but, instead, pertains to future forbearance of claims. They also should apply for unemployment benefits as soon as possible because they are entitled to receive them for a time period before severance is actually paid.

Compensation Conclusion

Severance is an important form of compensation for employees separated from their jobs. Both employers and employees have a significant interest in carefully negotiating, drafting, and enforcing these arrangements. As these cases reflect, severance can often be advantageous to both employers and employees in bringing a conclusion to the employment relationship. But you can expect the Doughboy’s devise to continue taking punches.

Marshall H. Tanick is an attorney with the law firm of Hellmuth & Johnson, PLLC, with offices located in Edina, Minneapolis, St. Louis Park and St. Paul. He is a certified as a Civil Trial Specialist by the Minnesota State Bar Association and represents employers and employees in various work-related matters.

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