Overview: Severance pay paid to employees who are terminated from employment is subject to payroll withholding for federal income tax (FIT), Social Security and Medicare (FICA) tax and federal unemployment insurance (FUTA) tax. For income tax withholding purposes, the Internal Revenue Service (IRS) treats severance pay as supplemental wages, i.e., wages paid in addition to employees' regular wages. As part of a severance pay package, employers may also provide supplemental unemployment benefits (SUBs).
The US Supreme Court unanimously ruled in United States v. Quality Stores, Inc., No. 12-1408 (U.S. Sup. Ct., 3-25-14), that severance payments made to involuntarily terminated employees that do not qualify as SUBs under the Internal Revenue Code are subject to Social Security and Medicare (FICA) taxes. The decision overturned a lower court ruling that could have required the IRS to issue more than $1 billion in refunds.
Author: Rena Pirsos, JD, Legal Editor
Updated to reflect the reduced supplemental withholding rates under the tax reform law enacted on December 22, 2017, effective January 1, 2018.
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