IRS Tax Rules for Employee Separation Benefits

When employment ends, any payments or benefits an individual receives are known as employee separation benefits. The tax treatment of these benefits varies depending on the type of payment, with some being fully taxable as wages while others may be partially or entirely excluded from income. The circumstances of the separation, such as a legal settlement, can also alter the tax implications. Understanding these Internal Revenue Service (IRS) rules is important for both former employees and employers to ensure proper tax compliance.

Common Taxable Separation Payments

When an employee leaves a company, they often receive several types of payments that the IRS classifies as taxable wages. Severance pay is one of the most common forms, and the IRS considers it wages whether it is paid as a single lump sum or in periodic installments. This means the entire amount is subject to federal income tax withholding.

Payments for unused accrued leave, such as vacation time or sick days, are also treated as taxable wages. When an employer pays out the value of this untaken time, that money is added to the employee’s final compensation. Similarly, any final bonuses or commissions paid out after employment ends are also defined as wages.

Because these separation payments are categorized as wages, they are also subject to Social Security and Medicare taxes (FICA). The employer is required to pay federal unemployment tax (FUTA) on this compensation. These payments are treated no differently than the regular salary the individual earned while actively employed.

Specially Treated and Nontaxable Fringe Benefits

The continuation of employer-provided health insurance under COBRA can be a nontaxable benefit. If an employer subsidizes COBRA premiums, the value of that subsidy is excluded from the former employee’s income. For this exclusion to apply, the employer must pay the insurer directly or reimburse the employee after receiving proof of payment. If the employer provides cash without proof it was used for premiums, the payment is considered taxable wages.

Outplacement services like career counseling and resume assistance can be a nontaxable benefit if they provide a “substantial business benefit” to the employer. This benefit could include promoting a positive corporate image, maintaining employee morale, or reducing the likelihood of wrongful termination lawsuits. However, if an employee is offered a choice between cash and the outplacement services, the value of the services becomes taxable income.

Educational assistance provided through a qualified program can also be a tax-free benefit. An employer can pay for a former employee’s courses as part of a separation package, and up to $5,250 of these benefits can be excluded from income annually. This exclusion requires the payments to be made under a written plan that meets the requirements of Internal Revenue Code Section 127.

Tax Withholding and Reporting on Separation Pay

Most taxable separation payments are classified as “supplemental wages,” which allows employers to use one of two methods for withholding federal income tax. The most common is the optional flat-rate method, where the employer withholds a flat 22% from the payment. This method is frequently used for its simplicity with lump-sum payments.

The second option is the aggregate method. With this approach, the employer combines the separation payment with the employee’s final regular wages and calculates the income tax withholding as if it were a single payment for a regular payroll period. This may result in a different withholding amount than the flat rate, depending on the employee’s W-4 elections. If total supplemental wages for the year exceed $1 million, the withholding rate on the excess amount is 37%.

Regardless of the withholding method used, all taxable separation payments and the associated taxes withheld are reported on the employee’s Form W-2 for that year. The total taxable payments will be included in Box 1 (Wages, tips, other compensation). The Social Security and Medicare taxes withheld will be shown in Box 4 and Box 6, respectively. This ensures that the income is properly recorded for the employee’s annual tax filing.

The amount withheld may not cover the total tax liability for the year, as the separation payment could push a former employee into a higher tax bracket. It may be necessary to review one’s overall tax situation and make estimated tax payments to avoid a large tax bill when filing a return.

Payments from Lawsuits and Settlements

Payments from legal actions related to employment termination, such as wrongful termination or discrimination lawsuits, have specific tax rules. The taxability of settlement funds depends on what the payment is intended to replace. If a settlement compensates for lost wages, back pay, or front pay, that amount is considered taxable wages, subject to income tax withholding and FICA taxes, and reported on a Form W-2.

Payments for emotional distress or mental anguish are also taxable but are not considered wages, so they are not subject to FICA taxes. This income is reported as “Other Income” on a tax return. An exception exists if the emotional distress results directly from a personal physical injury or sickness, in which case the damages are nontaxable.

Compensatory damages received for personal physical injuries or sickness are excluded from taxable income under Internal Revenue Code Section 104. If a settlement allocates funds to compensate for physical harm, that amount is not taxed. Punitive damages, however, are always taxable, even if related to a physical injury.

Attorney’s fees associated with the settlement also have specific tax implications. In many cases, the entire settlement amount, including the portion paid to the attorney, is considered part of the employee’s gross income. The employee may then be able to deduct the attorney’s fees as an above-the-line deduction. The IRS will respect the allocations in a settlement agreement if they are consistent with the substance of the legal claims.