Supplemental Unemployment Benefits: What It Means for Employers

What it means in practice

What the term means. Section 3402(o) defines supplemental unemployment compensation benefits for withholding, and Treasury regulation 31.3401(a)-1(b)(14) repeats the definition, borrowing two key phrases from the SUB trust regulations at 26 CFR 1.501(c)(17)-1(b). An involuntary separation includes a temporary layoff, even if the employer expects to rehire the worker, and a separation is not treated as voluntary just because a collective bargaining agreement allowed it, such as automating a department. "Other similar conditions" include cyclical, seasonal or technological causes. Separation for disciplinary reasons or because of age is not similar, so payments for those reasons are not SUB pay under this definition.

Where SUB plans came from. The IRS technical guide on SUB trusts (Publication 5727, TG 17, revised February 2024) traces the first major plans to 1955 automobile industry contracts. Payments generally depended on the worker also receiving state unemployment benefits, and an employee who quit or was discharged for misconduct was not eligible.

How SUB pay differs from severance pay. The Department of Labor says severance pay is usually based on length of employment, is not required by the Fair Labor Standards Act, and is a matter of agreement between employer and employee. Publication 15 (2026) lists severance pay among supplemental wages subject to Social Security, Medicare and FUTA tax. SUB pay is tied to a qualifying involuntary separation, and its employment tax treatment turns on plan design. In Quality Stores, the parties stipulated the severance was SUB pay, and the Court still held it FICA wages.

How SUB pay differs from state unemployment insurance. State unemployment insurance is paid by the state from employer contributions under each state's law; see state unemployment tax (SUTA) and the Federal Unemployment Tax Act (FUTA). SUB pay is a private benefit. Pennsylvania tells claimants that filing for state unemployment compensation is not a claim for SUB, which they must take up with the employer or union.

Federal income tax withholding. Section 3402(o)(1)(A) says any SUB payment "shall be treated as if it were a payment of wages by an employer to an employee for a payroll period." Publication 15-A (2026) says all or part of the payments may be taxable depending on how the plan is funded, that amounts returning the employee's own previously taxed contributions are not taxable or subject to withholding, that withholding applies whether the separation is temporary or permanent, and that withholding must be based on the employee's Form W-4. Under 26 CFR 1.501(c)(17)-3(a), benefits funded entirely by the employer are fully includible in gross income; when employees contribute, only the amount by which total benefits received exceed the employee's total contributions is includible.

Form W-4 when someone else pays. Treasury regulation 31.3402(o)-1(b) treats the employment relationship as starting on the date benefits begin to accrue for W-4 purposes. A W-4 the employee gave the former employer can be used by the entity paying the benefits if the former employer furnishes it or acts as that payer's agent, unless the employee files a new one.

A note on the flat rate. Publication 15 (2026) applies its 22% and 37% rates to supplemental wages, a list that names severance pay but not SUB pay, and directs SUB withholding under the W-4 and regular tables, so the IRS sources reviewed do not describe the flat rate as an option for SUB pay. The flat-rate mechanics are on the flat tax withholding page.

Social Security, Medicare and FUTA: the Rev. Rul. 90-72 test. Publication 15 (2026) shows SUB benefits as subject to income tax withholding but exempt from FICA and FUTA "under certain conditions." Publication 15-A (2026) lists the conditions from Revenue Ruling 90-72: (1) benefits are paid only to unemployed former employees laid off by the employer; (2) eligibility depends on meeting prescribed conditions after termination; (3) the weekly benefit is based on state unemployment benefits, other compensation allowable under state law, and regular weekly pay; (4) the right to benefits does not accrue until a prescribed period after termination; (5) benefits are not attributable to particular services; (6) no employee has a right to benefits until qualified and eligible; and (7) benefits may not be paid in a lump sum. TG 17 adds that lump sums fail because the amount is the same however long the person is unemployed, and that the ruling covers short work week benefits.

United States v. Quality Stores. Quality Stores, a retailer in Chapter 11, paid severance that varied by job grade and years of service and was not tied to state unemployment benefits, then sought a FICA refund of $1,000,125. On March 25, 2014, the Supreme Court unanimously held (Justice Kagan not participating) that the payments were FICA wages, because FICA defines wages as "all remuneration for employment," and that section 3402(o)'s "as if" wording does not narrow that definition. The Court noted the IRS still exempts severance tied to state unemployment benefits from income tax withholding and FICA, citing Rev. Rul. 90-72, but said it did not reach whether that exemption is consistent with FICA. TG 17 states that Rev. Rul. 90-72 remains in effect.

SUB trusts under section 501(c)(17). A trust that funds a SUB plan can be exempt from federal income tax if, under the plan, its money cannot be used for anything other than SUB benefits before all liabilities to covered employees are met, and if eligibility and benefits do not favor highly compensated employees under section 414(q). Benefits that bear a uniform relationship to pay are not discriminatory. Under 26 CFR 1.501(c)(17)-1, the trust must be part of a written plan and pay benefits set by objective standards, not trustee discretion, and it may pay sick and accident benefits only if they are subordinate to the separation benefits. TG 17 notes the trust applies on Form 1024 with Schedule J, files Form 990 each year, and may not pay death, vacation or retirement benefits, and employer deductions are limited by sections 419 and 419A. Trust status does not settle the Rev. Rul. 90-72 test.

Reporting. Under Treasury regulation 1.6041-2(b)(1), SUB payments treated as wages are reported on Forms W-2 and W-3. When a 501(c)(17) trust pays benefits subject to section 3402(o) withholding, 26 CFR 1.501(c)(17)-2(j) says the trust files the withholding returns and furnishes the statements required by section 6051 instead of Form 1099. Publication 15 (2026) says employers that withhold on SUB benefits file Form 941. On the W-2, boxes 3 and 5 hold wages subject to Social Security and Medicare tax, so whether SUB pay appears there depends on the Rev. Rul. 90-72 result.

ERISA. ERISA's welfare plan definition (29 U.S.C. 1002(1)) includes plans providing unemployment benefits. Whether a SUB plan carries welfare plan duties, such as a summary plan description, is a question for EBSA or benefits counsel.

How SUB pay interacts with state benefits. The DOL Comparison of State Unemployment Insurance Laws (2023) describes SUB plans as contracts under which unemployed people receive payments from an employer-financed trust so that state benefits plus SUB equal a set share of their weekly earnings. It identifies two types: plans with no vested interest that pay only after a company layoff, and plans with a vested interest that may pay for other reasons, such as illness or permanent separation. Supplementation by the first type without affecting state benefits is permitted everywhere except New Mexico, Puerto Rico, South Carolina and South Dakota. DOL adds that most states reduce or deny benefits for wages in lieu of notice and dismissal pay, which is a key reason SUB plans are structured differently from severance.

Where states differ: Pennsylvania (example). Pennsylvania pamphlet UCP-8 (REV 04-20) says a 1956 Pennsylvania Department of Justice opinion, No. 658, still in effect, is the basis for not deducting SUB from unemployment compensation. It lists features of an approved plan: the employer pays into a separate trust or account, employees have no vested rights, payments are designated as SUB and cannot be used for wages or recovered by the employer, and the amount depends on length of service. SUB pay, even from an unapproved plan, does not reduce unemployment compensation. Without department approval, though, SUB payments are covered wages subject to Pennsylvania UC tax. Approval requires IRS exemption from FICA and FUTA, with tentative approval possible while an IRS request is pending.

Step by step for an employer. (1) Put the plan in writing and define qualifying separations. (2) For FICA and FUTA exclusion, meet each Rev. Rul. 90-72 condition. (3) Check each state where laid-off employees will claim. (4) Collect a Form W-4 and withhold income tax on the taxable part of each payment. (5) Report on Form 941 and Form W-2. (6) If a trust is used, confirm 501(c)(17) status and filings. (7) Keep records of benefits paid and employee contributions.

Example 1 (illustration): weekly top-up. A plan promises laid-off employees 70% of regular weekly pay, minus the state weekly benefit. An employee earning $1,000 a week receives a $450 state benefit, so the plan pays $250. Income tax is withheld on the $250 under the employee's W-4. If the plan meets every Rev. Rul. 90-72 condition, no Social Security or Medicare tax applies; if not, the employee owes $19.13 (7.65% of $250, using the 2026 rates of 6.2% and 1.45%) and the employer pays a matching $19.13.

Example 2 (illustration): lump sum. An employer pays each laid-off worker a single $6,000 "SUB" payment, unrelated to state benefits. Under Publication 15-A the lump sum is not excluded, so it is subject to Social Security tax of $372 (6.2%) and Medicare tax of $87 (1.45%) from the employee, with the same amounts from the employer, as in Quality Stores.

Example 3 (illustration): employee contributions. An employee contributed $1,200 of after-tax pay to a jointly funded SUB trust and later receives $3,000 in separation benefits. Under 26 CFR 1.501(c)(17)-3(a), only the $1,800 by which benefits exceed contributions is includible in gross income and subject to withholding.

Question: Must employees receive state benefits to get SUB pay? It depends on the plan, but the Rev. Rul. 90-72 exclusion requires the benefit amount to be based on state unemployment benefits, and Pennsylvania says an employee generally is not entitled to SUB unless also eligible for state unemployment compensation.

Question: Can a SUB plan pay someone fired for misconduct? Not as SUB pay under the federal definition. The regulations treat separation for disciplinary reasons as outside "other similar conditions."

Question: Does Quality Stores make all SUB pay subject to FICA? No. It held that severance not linked to state benefits is FICA wages and left the Rev. Rul. 90-72 exclusion undecided; the IRS technical guide says that ruling remains in effect.

Recordkeeping. Publication 15 (2026) says to keep employment tax records for at least 4 years. A 501(c)(17) trust must keep records of separation and sick and accident benefits paid to each employee and, if employees contribute, each employee's contributions allocable to separation benefits (26 CFR 1.501(c)(17)-2(j)).

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