Taxes on severance pay can be unpleasant surprise

Employers, employees and former employees can all experience unpleasant surprises when it comes to severance. Not everyone has the same view or the same interest from a tax viewpoint, and the variation in responses to the situation can be large. You may get severance pay when you quit your job, are laid off, or fired.

You also might get severance later if you sue and settle. The paying employer (or former employer) might not think about exactly what the payment is for. It might be a payment in exchange for a release of liability. But both payors and recipients should consider it.

Whether or not pay is labeled "severance," and regardless of when it is paid, the IRS generally views severance like any other pay. It's taxed as wages, so is subject to withholding and employment taxes. If your employer hands you a severance check as you walk out the door, you may well expect it to have all the payroll deductions you're used to seeing on your regular paycheck.

But payroll deductions may be a big surprise if you've sued, and several years later are settling. You might be expecting a big check without tax withholding. Many people are surprised that a former employer can withhold taxes when you no longer work for them. How can a payment be "wages" subject to withholding, you might ask, if you haven't been an employee for years? If you sue for wrongful termination and settle many years later, isn't there a time limit? As it turns out, timing doesn't matter.

Whether you get a gross check for the full amount or one with payroll tax deductions depends on several variables. They include how careful your employer is about its tax obligations, and how it agrees to resolve your case. Most employment disputes are settled, and it is common to split a settlement between severance (treated as wages) and non-wage income.

The employer might agree that some of the settlement is pay for discrimination, emotional distress, or other non-wage income. The severance pay is subject to withholding and employment taxes. The rest would be paid on a gross check with no withholding and reported on an IRS Form 1099.

There are two parts to the tax puzzle, income tax withholding, and employment taxes. Income tax withholding involves the employer deducting tax money according to withholding tables, and sending it to the IRS under your Social Security number. Then, in January of the following year, the company will issue you an IRS Form W-2 showing your total income and the taxes withheld.

Although you might regard the income tax withholding part of the equation as mere timing, employment taxes get expensive. The employer and employee each pay half the employment tax. For some years, there was a controversy in the courts over whether all severance pay should be subject to employment taxes.

Arguably, severance pay isn't for services that have been rendered, but for services that will never be rendered. Even so, the IRS position has consistently been that any severance pay is subject to employment taxes. Not all courts have agreed with the IRS.

However, in 2014, the U.S. Supreme Court voted for the IRS, reversing a key taxpayer win in the 6th U.S. Circuit Court of Appeals. See United States v. Quality Stores, 2014 DJDAR 3730 (Mar. 25, 2014), What's more, the court voted 8-0 in favor of the IRS. The court ruled that severance is subject to tax under the Federal Insurance Contributions Act tax.

FICA consists of Social Security tax and Medicare tax. Employers pay Social Security tax of 6.2 percent and employees also pay 6.2 percent, or 12.4 percent total. Add to that the 1.45 percent employers pay for Medicare and another 1.45 percent for the employee. With over 15 percent of pay at stake up to the wage base of $127,200, and 2.9 percent thereafter, employers and employees both care.

Severance pay is sometimes defined as gap pay to cover a period after the employee finishes rendering services. Severance can be paid by company policy, required by state or federal law, or by agreement. In an employment action, where a plaintiff is claiming wrongful termination or discrimination based on age, race, gender, or disability, the tax slope can be slippery.

Often, a portion of the claim is for lost wages, back pay, front pay, or both. Equally often, some amount of the damages represents a payment for emotional distress, or other non-wage damages. The IRS recognizes this.

In fact, the IRS makes clear (in its instructions to Form 1099-MISC) that non-wage damages should be reported on a Form 1099, not on a Form W-2. All taxpayers instinctively know the difference between wage withholding, and receiving a Form W-2, versus no withholding, and receiving a Form 1099. Fortunately, plaintiffs and defendants customarily work out such issues as part of the settlement process.

It doesn't technically bind the IRS, but if the figures are reasonable, the IRS usually does not object. Plaintiff and defendant may arrive at an agreeable wage figure that is large enough to make the employer (or former employer) feel comfortable that it is complying with its withholding obligations. At the same time, the wage component should not be so large as to cause the plaintiff to refuse to settle.

There is a surprisingly wide spectrum of practices on such issues. On one end of the spectrum, I have seen employers who seem entirely unconcerned about withholding, when I think their withholding obligation is clear and unambiguous. On the other, I have seen employers who insist on withholding on one hundred percent of a settlement, even though it seems eminently clear (to me, at least) that the lion's share of the settlement should not be subject to withholding.

If you are an employer and you do not have an agreement, it is safest to assume that any pay labeled as "severance" will face employment taxes. The same is true for pay that looks like it might be severance, regardless of how it is labeled.