Employers offering severance payment to employees are typically uncertain about the payroll taxes that may apply to these additional payments. Severance pay is treated as “supplemental wages” because it is not a payment for services in the current payroll period but a payment made upon or after termination of employment for an employment relationship that has terminated. As supplemental wages, special payroll tax withholding rules apply. The Internal Revenue Service recently clarified its position on withholding for supplemental wages, including severance pay. Employers should also make sure that severance payments offered in conjuntion with a waiver and release comply with the ADEA and WARN requirments.
Revenue Ruling 2008-29 addresses nine different situations where supplemental payments are made to employees that require additional payroll tax withholding as follows:
- commissions paid at fixed intervals with no regular wages paid to the employee;
- commissions paid at fixed intervals in addition to regular wages paid at different intervals;
- draws paid in connection with commissions;
- commissions paid to the employee only when the accumulated commission credit of the employee reaches a specific numerical threshold;
- a signing bonus paid prior to the commencement of employment;
- severance pay paid after the termination of employment;
- lump sum payments of accumulated annual leave;
- annual payments of vacation and sick leave; and
- sick pay paid at a different rate than regular pay.
For the supplemental wage payments identified above that do not exceed $1 millon, the amount of income tax withholding is determined under the rules provided in § 31.3402(g)-1(a)(6) and (7). These paragraphs describe two procedures for withholding on supplemental wages: the aggregate procedure and optional flat rate withholding. The Revenue Ruling explains the application of the two procedures to each of the nine payment types. A Supplemental to Circular E also provides guidance on withholding in Publication 15 and Publication15A.