U.S. Supreme Court Ruling in Quality Stores Clarifies That Severance Pay is Taxable—in Most Cases

By: Mark D. Nelson and Alejandra Lara

On Tuesday, March 25, 2014, the U.S. Supreme Court, in an 8-0 decision, ruled in Quality Stores, Inc., et al., 12-1408 that severance payments made to employees who are involuntarily terminated are taxable wages under the Federal Insurance Contributions Act (FICA).  The Court reversed the Sixth Circuit Court of Appeals ruling in favor of Quality Stores, which was seeking a $1 million tax refund based on its argument that severance payments were not covered by FICA and were excluded from taxation based on the Internal Revenue Code.  The Court’s ruling resolved a split between the Sixth Circuit and the Federal Circuit, and ended a legal battle with more than $1 billion at stake in potential tax refunds to employers involved in 11 separate cases with more than 2,400 refund claims.

Quality argued that its severance payments to terminated employees were actually supplemental unemployment compensation benefits (SUB), which are not considered “wages” under the Internal Revenue Code.  According to the company, “a SUB payment is a type of payment that—although made by an employer to [its] former employee—nonetheless does not meet the statutory definition of ‘wages’ because it is not remuneration for services.”  The Court noted that the severance payments were made only to employees and were based on employment-driven criteria including the position held, the employee’s length of service with the company and salary at the time of termination.  Relying on the “broad definition of wages under FICA,” the Court ruled that severance payments to employees who are terminated involuntarily are taxable under FICA.

However, in its decision the Court noted IRS revenue rulings that severance payments tied to the receipt of unemployment compensation benefits “are exempt not only from income tax withholding but also FICA taxation.”  Thus, employers appear to continue to be able to make severance payments that are exempt from income tax withholding and FICA through a carefully crafted structure linking the severance payments to the employee’s receipt of unemployment compensation benefits.

If you have any questions about the impact of this decision, please contact Mark Nelson or Alejandra Lara, or any other member of the Labor & Employment Group.

Ten Considerations in Drafting Executive Employment Agreements

By: David J. Woolf

Perhaps your company has just acquired a new business and wants to put that entity’s employees under a more structured employment arrangement.  Or maybe you are just looking to roll out new executive-level agreements within your own company.  Whatever the motivation and circumstances, here are ten things to think about in drafting employment agreements that often go overlooked: 

  1. Severance – The most common question is the easiest: Are you going to provide severance and, if so, how much?  Other details merit consideration though.  For example, is death or disability a severance trigger?  As part of the package, do you want to provide things like medical benefit continuation, prorated bonus, equity vesting acceleration, extension of the option exercise period, or other benefits?  Whatever you do, the employer will want to make sure that the executive has to execute a release to receive the severance benefits, other than vested benefits and accrued compensation.
  2. Fixed Term (or Not) – Traditionally, a term contract was like a baseball contract – the executive had a term and, except where the employer had good cause for an early termination, it had to pay the executive out through the end of the term no matter what.  That concept seems to have largely disappeared, in that (a) employers don’t want to be saddled with paying out the full term if they elect to make a change earlier and (b) executives want severance even when the agreement expires naturally and is not renewed by the company.  As a result, except where the employer can secure a true no obligation walk away at the end of the term, or at least establish some difference between an in-term and end-term separation, an employer would be wise to go with an at-will arrangement with no set term.
  3. Restrictive Covenants (or Not) – Restrictive covenants, including covenants not to compete, require clearer, more definitive consideration than most contract terms.  And aside from new employment, there is no better consideration than new or enhanced compensation and benefits memorialized in a formal employment agreement.  So, if you think non-competition, customer non-solicitation, or other restrictive covenants are worthwhile (and you usually should at the executive level), the employment agreement (or a separate, contemporaneously-executed and cross-referenced restrictive covenant agreement) is the place to do it.
  4. Cause – “Cause” means different things to different people.  From an executive’s point of view, Cause is often engaging in particularly serious conduct that is not rectified after notice and an opportunity to cure.  Employers, however, should seek to include things like the executive’s failure to perform his or her duties; violation of material company policies (such as anti-discrimination and harassment policies); commission of a felony or other serious crime; breach of his or her restrictive covenants, fiduciary duty, or other misconduct; and material misrepresentation of experience or education, among other things.
  5. Good Reason Provision (or Not) – A “Good Reason” separation provision allows an executive to resign for certain preapproved reasons – typically the employer’s material breach of the employment agreement, a required relocation, or a material diminution of the executive’s duties, often after the employer has failed to cure – and collect severance as if he or she was fired without Cause.  Most savvy executives have come to expect such a provision, and providing it to the executive can be a relatively easy give if the Good Reason provision is drafted correctly.
  6. Award Equity (or Not) – Many executives, particularly when accepting a role in a new or newly-acquired company, understand that the cash compensation may be limited initially.  What they really want is equity or options so that, if they succeed in developing the company, they can share in that success.  Employers and equity firms often find this arrangement beneficial too in that it limits cash outlays and aligns incentives.   
  7. State Law and Venue Selection – Almost all employment agreements include a choice of law provision, and many, if not most, employers instinctively select the state in which the company operates and the executive will work.  But that may not be the best law for the employer and other options may be available.  For example, most courts will apply another state’s law if there is a nexus to that state, such as it being the employer’s state of incorporation.  Venue is equally important, as requiring an employee to litigate in a certain forum can give the employer litigation location certainly and potentially avoid the executive running to another state where the law (for example, concerning non-competes) is more favorable.
  8.  Assignment – Often forgotten, the assignment provision is critical in that, without it, many states’ laws will not permit assignment, even upon a sale of the employer’s assets.  To avoid this, the employment agreement should state that, although the executive may not assign the agreement, the employer may do so, at least to an affiliate or as part of a transaction.
  9. 409A – When possible, severance, other payments and the agreement generally should be structured so as not to trigger coverage under Section 409A of the Internal Revenue Code.  If the agreement is subject to Section 409A, it should be written to comply with it.  Failure to do so can expose the executive, among other things, to a 20 percent additional tax and the employer to an angry executive.
  10. Miscellaneous – There are of course numerous other things of value that an employer can do.  For example:

●  The salary section can allow for the reduction of the executive’s salary when executive salaries are being cut across the board. 

●  The employer may want to make any bonuses contingent on the executive working through the end of the year.

●  In most states, an employer can provide that accrued, unused vacation and PTO will not be paid out upon termination of employment.

●  Arbitration, subject to a carve out for injunction actions, has its positives and negatives and should be considered.

●  Address what is to happen upon a sale of the employer or other change of control.

●  New executives should represent and warrant that they are not bound by any restrictive covenants that would limit their ability to work for the employer and that they will not use any confidential information from their former employer.

●  Although largely standard now, employers should take care to ensure that the agreement provides that it can be revised only by written document. 

●  Make sure the agreement works with other documents and that the integration clause doesn’t unintentionally overwrite other agreements.

There are always more issues of course, particularly those specific to the particular company and the executive.  But the ten-plus areas above arise frequently and thus typically merit consideration.

Hiring Employees Who May Be Bound by Post-Employment Restrictive Covenants? Caution, Restrictions May Apply

By: Daniel H. Aiken

Employers frequently want to hire talented employees who are bound by post-employment restrictive covenants (e.g., non-competes, or customer/employee non-solicitation covenants).  Often, a plain reading of the prospective hire’s agreement raises questions about whether joining your company would violate the agreement.  This requires strategic, and sometimes creative, planning.  Depending on your jurisdiction, deciding to hire an employee despite their post-employment restrictive covenants may involve taking a calculated risk that some parts of the post-employment restrictions are not enforceable, while deciding that there are some aspects your company can live with and that you expect the new employee to follow.  The following provides some basic guidance.

1.  Assess the business impact of the restrictions by determining the precise scope and duties of the prospective job.  Even though the individual may be subject to post-employment restrictive covenants, the job for which you intend to hire him/her may not fall within the restrictions.  Or, inasmuch as most restrictive covenants will expire — sometimes in a matter of months — you may decide that the company can tailor the scope of the intended position so that the new employee can still add value, but not perform work that would violate the individual’s obligations to his/her former employer.  Can the person be employed in a capacity that does not violate the restrictions until they lapse?  Can the person be employed outside the geographically restricted area or assigned to existing customers different from those of the former employer?

2.  Review and analyze the legal risk.  Analyze the true legal risk of proceeding.  By “true” legal risk, I mean the likelihood that the former employer will succeed if it takes legal action, as well as the likelihood the former employer will actually take legal action.  This should include an analysis of the scope of the restrictions and their enforceability given the applicable state law, whether the action will be brought in federal or state court, as well as an assessment of the likelihood that a court will enforce the restrictions.  This will vary according to the applicable state law and circumstances.  You should also consider more practical issues such as the former employer’s litigation history, the importance of the potential hire to the former employer, and the extent to which employment with your company differs from the prior employment.  Other practical considerations should include a review of the industry and whether post-employment restrictions are commonplace, whether the two companies compete for the same customers, and a frank review of your company’s flexibility in defining the scope of the intended position.

3.  Hire away, or don’t, but proceed with caution.  Having analyzed the legal risk and business impact of the restrictive covenants on your proposed hire, determine whether you are comfortable proceeding with the hire in the intended position, or if there is a different, or modified position, that would still suit the company’s needs while lessening the legal risk.  Analyze and take available appropriate steps to minimize the risk of being sued, or, if sued, the risk of a lengthy or costly suit.  Communicate, in writing, what you expect of the new employee.  For instance, you and counsel may reach the conclusion that the prospect’s non-competition restrictions are overly broad and will not be enforced under the circumstances, but that a court is likely to enforce a customer non-solicitation covenant.  Accordingly, you may decide to move ahead with the hire, and plan to keep the new employee away from former customers.

Typically, the  company’s offer letter is a good place to memorialize such expectations.  In our scenario, the offer letter should state, as a condition of employment, that the new employee does not possess and/or will not use his former employer’s confidential information and that the employee will not solicit former clients (as well as any other restrictions that your company expects to be followed).  The employee, especially if sophisticated or if represented by an attorney, may seek indemnification for any legal action taken by his former employer.  Determine whether you are willing to entertain such a request.  Consider also what type of an “out” you have, both of the employment relationship and/or indemnification, i.e., what recourse does the company have if ensuing litigation is going badly or you find the new employee was not truthful about not taking any confidential information from the former employer?

4.  Protect your company from the beginning.  Companies often get into trouble when recruiting a prospective employee long before the actual hire.  Employees may pitch their importance by showing you their customer list or sales volume, but these items are likely to be considered confidential by their employer, if not trade secrets.  Further, the employee may offer to bring with them a junior colleague and provide you with confidential information about the employee or may start contacting customers about his or her intentions.  Those actions may have already violated the person’s restrictive covenants.  Ground rules for such activity should be established during the interview process, in writing, if possible.  Also obtain written confirmation that the potential hire is not under any undisclosed restrictions and communicate, in writing, that the prospective employee is not to disclose or use confidential information or trade secrets and is not to take or bring any property or information belonging to the employer.  Follow through and make sure the person complies fully with those requirements.

Although there is no way to prevent a suspicious former employer from challenging your company’s hire of one of its employees, following this guidance will place your company in a better position in the event of such a challenge.

Taylor v. Nabors Drilling and California’s SB 292 Clarify that Sexual Harassment Need Not Be Motivated by Sexual Desire

By: Saba Shatara

On January 13, 2014, the California Court of Appeal decided in Taylor v. Nabors Drilling USA, L.P., 222 Cal. App. 4th 1228 (2014), that a person may maintain an action for sexual harassment when subjected to verbal attacks on his or her heterosexual identity, regardless of whether the attacks were motivated by sexual desire.  This ruling came soon after the implementation of SB 292, which became effective in California on January 1, 2014.  This bill revised the definition of sexual harassment under California Fair Employment and Housing Act (“FEHA”) to specify that sexually harassing conduct “need not be motivated by sexual desire.”  As a result, to prove harassment “because of sex,” plaintiffs need only show that there was evidence that gender was a substantial factor in the harassment. 

Both Taylor and SB 292 explicitly reject the view adopted by the California Court of Appeal in Kelley v. Conco Companies, 196 Cal. App. 4th 191 (2011), which held that a plaintiff failed to prove sexual intent because there was no evidence that heterosexual harassers sexually desired the male plaintiff.  The court made this decision despite the fact that the defendant and coworkers in Kelley used “graphic, vulgar, and sexually explicit” language to express sexual interest and solicit sexual activity from the plaintiff.

Taylor and SB 292 resolve any ambiguity created by the Kelley decision, and make clear that a showing of sexual desire is not an essential element of a claim of sexual harassment—thereby affirming and solidifying California authority published before Kelley.  Thus, it is clear that a plaintiff may establish an inference that an alleged harasser’s conduct is sexual by producing: (1) evidence of the alleged harasser’s sexual desire; (2) evidence that the alleged harasser is motivated by general hostility towards the particular gender of which plaintiff is a member; or (3) comparative evidence about how the alleged harasser treated members of both sexes in a mixed-sex workplace.  

These developments in California sexual harassment law have important consequences for employers.  To avoid a greater occurrence of suits, employers must now scrutinize offensive comments by same-sex employees objectively, based on the content of the remarks, not the intent of the speaker.  Employers can minimize liability through adequate complaint protocols, instituting zero tolerance policies, and encouraging employees to report any inappropriate workplace behaviors.  These actions may prevent alleged harassing conduct from being deemed sufficiently severe or pervasive.  Employers should also stress that bullying, such as the use of homophobic epithets to heterosexual employees (Taylor), subjects the employer to liability.  Accordingly, employers should update their policies and handbooks to reflect the change, as well as provide employees relevant information and a copy of the updated policy.  Lastly, employers may consider additional training for supervisors or issuing a memo, advising them of SB 292 and their responsibilities to administer policies in conformity with the new law.