Taxation of Terminations, Settlements and Judgments
June 28, 2010
by David M. Repp
Unless specifically exempted, every employer making payment of wages to an employee is required to withhold Federal
income taxes and to pay such withheld taxes to the United States Treasury. IRC § 3402(a)(1). The term “wages” is
defined as all remuneration for services performed by an employee including the value of remuneration paid in a
medium other than cash unless specifically excluded. IRC § 3401(a). A similar (but not identical) set of rules apply to
FICA withholding. IRC §§ 3101; 3121(a). This article discusses some of the more common forms of compensation paid
to a terminating employee and whether such payments are subject to income tax and FICA withholding.
Severance Pay. The most common type of payment to a terminated employee is severance pay, which is taxable
compensation income. IRC § 61; Ramella v. Comr. 1979 TCM 177. Severance pay is taxable even if, as part of their
separation agreements, departing employees sign waivers releasing their former employers from potential future
claims, including claims of unlawful discrimination. Webb v. Comr., 1996 TCM 50; Sodoma v. Comr., 1996 TCM 275;
Foster v. Comr., 1996 TCM 276. Amounts paid to a terminated employee are compensatory and taxable as severance
pay, even where the employer had no legal obligation to make the payments. Schwartz v. Comr., 1989 TCM 97.
Severance or dismissal pay is treated as supplemental wages and fully subject to federal income tax withholding. The
IRS allows two alternative withholding methods on severance pay: the flat rate method and the aggregate method. IRS
Information Letter 2010-0042.
Optional flat rate withholding method. This method allows an employer to withhold from the severance
payment at a flat rate of 25% without regard to the employee's filing status or allowances claimed on Form W-
4. An employer may only use this method if it has also withhold income tax from regular wages paid to the
employee during the same calendar year as the severance payment, or in the preceding calendar year if the
supplemental wages are separately stated on the employer's payroll records.
Aggregate method. Under the aggregate method, the employer adds the supplemental and regular wages (if
any) for the most recent payroll period in the current year together, and then figures the income tax
withholding as if the total were a single payment. This calculation takes into consideration the employee's filing
status and withholding allowances. Employers may use this method in any situation where they are paying an
employee supplemental wages that do not exceed $1 million in a calendar year.
However, whether severance pay is subject to FICA tax withholding is less than clear. Treas. Reg. §§ 31.3401(a)-1(b)
(4), 31.3402(g)-1(a); Rev. Rul. 74-252. In 2002, the Court of Federal Claims held that severance pay was not subject
to FICA (CSX Corp. v. U.S., Ct of Fed Cl 4/1/02). However, in 2008, the Court of Appeals for the Federal Circuit
reversed and held that the severance pay involved in the taxpayer's various downsizing programs was subject to FICA
(CSX Corp. v. U.S., (CA FC 3/6/2008) 101 AFTR 2d ¶2008-553. Most recently, a Federal District Court has held that
severance is not subject to FICA withholding. U.S. v. Quality Stores, Inc., 105 AFTR 2d 2010 ¶533 (DC MI, 2/23/2010).
Back Pay. Back pay is compensation paid to an individual to compensate him or her for pay he or she would have
received up to the time of settlement or court award but for the employer's wrongful conduct. For example, back pay is
awarded to an employee if he or she is illegally terminated by an employer, or to an applicant for employment who is
not hired for illegal reasons. In most cases, back pay is taxable, subject to FICA and income tax withholding, and must
be reported on Form W-2 in the year payment is received (rather than the year payment should have been received).
Cleveland Indians Baseball Co. v. U.S. 532 U.S. 200 (2001). Back pay for lost wages received on account of personal
physical sickness or physical injury is not subject to FICA and income tax withholding. Anderson v. United States, 929
F.2d 648, 654 (Fed. Cir. 1991) (payments which are excluded from IRC § 61’s definition of “gross income” are not
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