How to Pay an Employee's Final Wages
Author: Alice Gilman
Most employees are considered at-will employees, which means, absent some discriminatory reason, they can be terminated at any time for any reason. On the other hand, an employee may resign for any reason or may retire. But whatever the reason, a separation from employment is the catalyst for a series of actions, including the payment of final pay, the determination of what items must be included in the final wage payment and the income tax withholding method that will be applied to those items. State wage payment laws govern most of these considerations and they include stiff penalties for an employer that fails to comply.
A payroll manager should never guess why a separation is occurring but, instead, should discuss it with the employee's immediate supervisor or HR and get documentation of the nature of the separation before making the final wage payment. Ancillary documents, such as an employment contract or collective bargaining agreement, should also be checked to determine whether any additional payments must be made upon an employee's separation.
Step 1: Determine the Nature of the Separation
While an employee's separation may be voluntary or involuntary, there are gray areas in between. Since the legal requirements regarding when to pay an employee's final wages varies depending on the type of separation, it is critical that the employer properly identify the nature of it.
The following exemplify the possible scenarios:
- A voluntary separation occurs when an employee notifies the employer that he or she is leaving employment or retiring, or when an employee dies.
- An involuntary separation occurs when an employee is fired or laid off.
- An employee is constructively discharged when he or she feels forced to resign due to intolerable working conditions.
- Depending on the circumstances, if an employee who gives notice of his or her resignation is subsequently fired, it is prudent to treat the separation as involuntary.
Step 2: Assemble the Needed Paperwork
As soon as it is known that an employee's employment has ended or will end, for whatever reason, the employee's immediate supervisor should initiate a separation document and send it to the HR, payroll and benefits departments. The document should indicate the employee's last day of work and the reason for the separation from employment (i.e., voluntary, involuntary, retirement or death). Supporting documentation should be attached that includes enough detail to assist with the processing of the employee's unemployment compensation claim, assuming he or she is eligible.
Step 3: Review State Laws
An employer's separation pay policies must comply with the final wage payment laws of all of the states in which the employer does business. State laws governing final wages usually dictate the following things:
- The applicable payment deadline, depending on the type of separation (e.g., a state law may require immediate payment of final wages if the employee is fired, but payment at the next regular payday if the employee resigns);
- Whether the separating employee's accrued vacation balance and the value of other accrued time must be included as part of his or her final wages;
- Whether loss-related deductions (e.g., an employee damages employer goods) or deductions for debts (e.g., an employee borrowed time from his or her accrued leave) may be made from the employee's final wages; and
- Applicable penalties. If an employer is late in paying final wages or fails to pay all wages due to a separated employee, the employer may be required to pay penalty wages to the employee. Penalty wages are usually paid daily (the maximum length varies by state) and equal the amount of the employee's final wages.
If an employer is located in a state without a final wage payment law, it is acceptable to pay an employee's final wages on the next regular payday.
Acme Corporation does business in California and Oregon. In California, an employee who is involuntarily terminated must be paid immediately, at the time of termination. In Oregon, an employee who is involuntarily terminated must be paid by the first business day after the termination.
If Acme wants to have a one-size-fits-all final pay policy, it would have to follow California's law since it is the most stringent.
Step 4: Check Company Policies
After ensuring that the employer's final pay policy complies with applicable state law(s), a payroll manager should examine the details of the policy. Final pay policies can vary considerably depending on the circumstances of a separation. A final wage payment that does not comply with the employer's policies could result in litigation and penalties.
While there are many legal and practical considerations that go into the creation of a final pay and severance pay policy, a final pay policy typically covers the following items:
- Whether an employee must provide notice of separation and how much notice is required;
- The consequences to the employee of failing to provide proper notice;
- The circumstances under which severance pay is payable, if any;
- Whether, in accordance with state law(s), the employee's accrued vacation pay and the value of other accrued time off will be paid as part of final pay, and the circumstances under which it will be paid (e.g., the payment of accrued vacation will be forfeited if the employee does not provide adequate notice of his or her resignation);
- Whether, and how, offsets from final wages will be made, if the separating employee owes the employer a debt or is liable for a loss-related deduction;
- When final pay will be paid, in accordance with state law(s); and
- How final wages will be paid (i.e., by paper check, direct deposit or paycard).
Under Acme's final pay policy, an employee is not entitled to severance pay if he or she resigns, retires, is fired for cause or is absent from work due to a disability that is covered by workers' compensation.
An employee who resigns will be paid through the last day of work and will receive the final check on the first payday following his or her resignation. If the employee has completed the initial six-month probationary period, he or she will be eligible for the payment of all vacation time earned but not taken at the time of resignation, up to the maximum accrual allowed.
Accrued sick time and personal vacation time will not be paid upon resignation or involuntary termination.
In addition, Acme's final pay policy covers the following points for employees who are laid off:
- An employee who completed one year of continuous, regular employment is eligible for severance at the time he or she is laid off; and
- An employee who has passed his or her probationary period and is involuntarily terminated for any reason, other than poor job performance or misconduct, is eligible to receive either four weeks' notice of termination or four weeks of pay in lieu of notice. An employee who has at least 10 years of service is eligible to receive a minimum of eight weeks' notice (or pay in lieu of notice) prior to layoff. An employee with fewer than 10 years of service is eligible to receive a minimum of four weeks' notice.
Regarding severance pay, an eligible employee will receive one full week of severance pay per completed year of service for the first 10 years of service. For all completed years of service beyond the first 10, the formula is two full weeks of pay per year. The maximum is 52 weeks. An employee must sign an agreement and release satisfactory to Acme to receive severance pay.
Step 5: Examine Employment Contracts
Executives often work under employment contracts that contain provisions regarding payments related to separation from employment. The potential payments due may vary depending on the type of separation. For example, a separation related to a merger or acquisition may trigger the payment of nonqualified deferred compensation or a golden parachute (a contract between a corporation and key employees under which the employees will receive payment if the company is sold or undergoes a change in control) payment. Or, an executive who retires may receive a cash bonus or stock options as part of his or her retirement package.
A payroll manager must determine whether a golden parachute payment is an excess golden parachute payment (a payment that exceeds three times the executive's base amount - his or her average annual compensation for the most recent five years). If it is, then a 20% excise tax must be withheld from the final payment.
Alison Moore is an executive of Acme Corporation. Written into her employment contract is a clause that requires Acme to pay her $400,000 if the company is merged with or acquired by another company. Over the preceding five-year period, Alison's average pay was $100,000.
Acme was bought by its competitor and the contract clause was activated. The $400,000 payment to Alison is an excess golden parachute payment, since it is more than three times greater than her average salary over the last five years. Acme's payroll manager must withhold 20% as an excise tax, or $60,000.
Step 6: Create a Contingency Plan
Occasionally, it may not be possible to comply with a state's law on paying an employee's final wages. For example, if an employee separates without notice, the payroll manager may not be able to process the payment concurrently with the separation. In such cases, the employee could technically be kept on the payroll until the final payment can be executed.
Step 7: Choose an Income Tax Withholding Method
Income tax withholding on a separated employee's final regular wage payment should be calculated using the employer's usual withholding method. However, there are four income tax withholding methods applicable to severance pay that is treated as supplemental wages, such as for a lump-sum severance payment or the payment of overtime or commissions:
- Withholding at the flat 25% rate for supplemental pay up to $1 million;
- Withholding at the flat 39.6% rate for supplemental pay in excess of $1 million;
- The aggregation method; or
- Grossing up the payment, if the employer opts to pay the employee's taxes.
Acme Corporation is terminating four employees, each of whom is entitled to a lump-sum severance pay package equal to three times his or her departing salary, including bonuses: (i) Douglas Green, a floor supervisor; (ii) Jennifer Barnes, a senior account executive; (iii) Mary Keene, an administrative assistant; and (iv) William Elliot, an executive vice president.
The income tax withholding rules do not require Acme to apply the same supplemental withholding method to each terminating employee. The tax rules also make clear that, although the employee can request a particular withholding method, the decision of which method to use is strictly Acme's. Acme, therefore, decides to withhold in the following ways for each of the four employees:
- For Douglas Green, Acme uses the 25% flat withholding rate. Green's final salary is $75,000, so the withholding on Green's severance is $56,250 ($75,000 × 3 = $225,000 × 25%).
- For Jennifer Barnes, Acme must withhold at the 39.6% rate because her total supplemental pay exceeds $1 million: $150,000 in payable bonuses, plus three times her regular salary of $300,000. Acme may withhold 39.6% on the entire payment, in which case the withholding equals $415,800 ($900,000 + $150,000 = $1,050,000 × 39.6%), or it may withhold 25% on the amount up to $1 million ($250,000) and 39.6% on the amount exceeding $1 million ($19,800).
- For Mary Keene, Acme treats her severance as regular wages. Keen's final salary is $40,000 a year. Her lump-sum severance equals $120,000. To use the aggregation method, Acme adds the $120,000 to Keene's wages paid for the preceding pay period, withholds on the total, and then subtracts out the amount withheld from her regular wages. Acme withholds the remaining tax from the supplemental wages.
- For William Elliot, Acme must gross up the taxes because that provision was included in his employment contract. Elliot's severance equals $3,500,000. The gross up for income taxes equals $5,794,701.90 because Acme chooses to use the 39.6% rate on the entire payment ($3,500,000 ÷ 1 - 0.396 = 0.604)
For each of these terminated employees, Acme must withhold Social Security taxes on the amount of severance paid up to that year's taxable wage base. Acme withholds Medicare taxes at the rate of 1.45% on severance paid up to $200,000 and at the 2.35% rate on the remainder. Acme must match all of the Social Security tax withheld, but continues to be liable at the 1.45% rate for the employer's portion of Medicare on all severance paid.
Step 8: Execute the Final Payment
Once a payroll manager is satisfied that the final pay documentation meets all applicable state laws and company policies and the proper withholding method for supplemental pay has been chosen, the final payment may be executed. The following things must be determined in order to make the final wage payment:
- What goes into the final payment? In addition to final wages, the employee may be owed overtime, a production-related bonus, commissions and the value of accrued vacation or other time off.
- What should be deducted from the final payment? As a general rule, all voluntary deductions that are made from a regular wage payment may be made from a final wage payment.
- How much income tax should be withheld from overtime pay, bonuses, commissions, accrued vacation and other time (these payments may be treated as supplemental wages for federal income tax withholding purposes)?
- How should the final payment be made? By the employer's usual payment method or by paper check? Note that in states that require immediate payment of final wages, paying via direct deposit or paycard may not be appropriate due to the time needed to process electronic payments.
If a final wage payment is being made because an employee died, the following steps must also be followed:
- Cancel the employee's usual direct deposit or paycard payment and make the final payment by paper check;
- Request that the deceased employee's estate or beneficiary provide the appropriate Taxpayer Identification Number by sending Form W-9 to the appropriate party; and
- Inform accounts payable, or any other department that handles Form 1099-MISC, of the amount of accrued wages and other payments that must be paid after death.
A payroll manager should honor, within 30 days, a separated employee's request for early receipt of his or her copy of Form W-2, Wage and Tax Statement. To ensure proper delivery of the form to the employee, the payroll manager should make sure that the employee's address is correct prior to releasing the final check.
If the final check will not be hand delivered to the former employee, the check should be mailed certified, return receipt requested.
If the check is returned to the employer uncashed, the employer must retain it until it becomes abandoned property. If that happens, the employer must comply with state law procedures on unclaimed wages and other abandoned property. The employer must complete a report and remit it to the state of the employee's last known residence. If the employee's state of residence is unknown, the check must be remitted to the state in which the employer is incorporated.
Step 9: Ensure Post-Separation Notification Duties Are Fulfilled
- Under COBRA, a terminated employee and his or her family members are entitled to a notice of their health care continuation rights within 30 days of the termination. The employer, therefore, should ensure that the health plan administrator is notified of the termination in a timely manner.
- In addition, if the employee's wages were subject to an order to withhold child support, the employer should notify the state child support agency that the employee no longer works for the employer and provide the name and/or address of the employee's new employer, if known, within the state-mandated deadline.
- Likewise, if the employee's wages were subject to a creditor garnishment order, the employer should notify the creditor and the court that issued the order of the separation.
- The employer should also promptly provide the appropriate state unemployment agency with the appropriate information regarding the employee's separation.
- To assist with the reporting of offers of group health insurance under the Affordable Care Act, the payroll manager should record the employee's last day of work, his or her health coverage at the time of separation, and whether he or she elected continuing health coverage under COBRA. This information should be passed on to the party who will be completing the health insurance information-reporting forms.