Should Your Nonprofit Offer Severance Pay?

Severance pay should be considered whenever an employee is laid off, is terminated with or without cause, or resigns from employment. Termination can result from a variety of circumstances, some of which may involve contentious people or situations, and difficult issues.

Thus, severance pay may be a good risk-management tool for avoiding potential 
litigation, adverse publicity and other claims against a nonprofit employer.

Nonprofit organizations should avoid any communications, such as in employee handbook provisions, that would lead employees to reasonably expect severance pay upon 
termination. Additionally, nonprofit 
employers should be careful about consistency among employees, to avoid later claims of inequity and even unlawful discrimination among differently treated employees. Severance pay should never 
be presented or perceived as a bribe. 
Finally, it should not be utilized as a substitute for retirement benefits, because tax rules apply to deferred compensation.

In addition, a nonprofit organization should consider whether unemployment compensation benefits will be available 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 four total employees on staff 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 reason for severance pay.

Tax Issues

Keep in mind: No payments—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 a quid pro quo arrangement (e.g., reasonable wages paid for work performed) or other payments that further the organization’s tax-exempt purposes—benevolence for religious organizations, grant-making and scholarships for charities, etc.

When insiders improperly benefit, this is known as “inurement” and is illegal. For insiders who are in a position to 
exercise substantial influence over a nonprofit, their receipt of improper financial benefits may result in substantial excise tax liability for both them and the organization, 
under section 4958 of the Internal Revenue Code.

Not a Gift

Some have argued to the IRS that severance payments amount to legitimate non-taxable income because they constitute gifts. This argument has been raised repeatedly by churches and pastors. However, the term “gift,” at least for tax purposes, means something given “from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses.”

The key consideration is the transferor’s intent. If an organization 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. Obviously, this is a serious issue. Thus, the recommended approach is to never categorize severance pay as a gift.

Summing Up

Severance pay can be a great tool for nonprofit organizations. There are 
several benefits to keep in mind. 
Providing severance pay may help to avoid litigation when dealing with 
difficult employees or termination situations. Severance is a legal way to thank good employees for their service to the organization. And severance pay may serve as a good alternative to unemployment compensation in situations where unemployment is not available because of religious exemption, organization size or other factors.