07/31/2012 01:06 pm ET | Updated Sep 30, 2012

Severance Pay and Federal and New Jersey Taxes

To ease the impact of layoffs, promote goodwill among remaining employees and prevent employment related lawsuits, employers customarily award severance pay to their former employees. There are some income, employment and possible excise tax implications to the employer and former employee with respect to severance pay.

Tax Implications

Severance pay is typically classified as wages and has the similar income and employment tax consequences, even though this payment may not be classified as wages for non-income tax purposes. This is the case whether the employer pays the severance after the employer/employee relationship has been terminated and whether the employee receives the severance in exchange for (1) not pursuing legal action against the employer; (2) cancelling an employment contract; and (3) rights accruing during employment, such as unused sick and vacation days, tenure and stock appreciation or phantom stock credited to an employee. For purposes of employment taxes, wages include any payments made on account of involuntary separation from the employer, whether or not the employer is legally bound to make them.

The employer can deduct this severance pay in the year it pays or incurs this expense if it meets certain conditions, among which is that the severance pay must be deemed to:

-be a reasonable allowance for personal services actually rendered.

-provide only a current year benefit, subject to some exceptions; otherwise, it may have to be capitalized.

-be unrelated to goodwill or customer lists (as in the case of a sales employee); otherwise, it would have to be capitalized and deducted ratably over 15 years.

The employee, notwithstanding the tax implications to the employer, would be taxed on this payment at his or her ordinary income rates, and not capital gains rates, in the year received.

Additionally, if the employer makes a severance payment upon the sale of either itself or a substantial part of its assets, an employee could be subject to a 20-percent excise tax with respect to some or all of the severance payment, commonly referred to as a golden parachute. Generally, this could occur if the payment greatly exceeds an employee's annual salary, unless the employer could establish that the severance payment is based upon merit. For example, in the case of a former employee who was a salesperson, the employer may be able to establish that the payment was reasonable if based upon sales he or she generated.

Tax Reporting

The employer would report severance pay on an employee's Form W-2, box 10. The employer may withhold federal income taxes with respect to the severance payment at either a flat 25-percent rate or use withholding tables with gross wages equal to the combination of the regular wages and severance pay, but must withhold New Jersey income taxes based upon the combination of the regular and severance pay. The employee, other than reporting the amount as per the Form W-2, should not have any other tax reporting obligations.

Tax Planning

The employer could substitute part of the severance pay with non-cash benefits that would have identical income tax consequences to the employer, but would be non-taxable to the employee and not subject to employment taxes for either of them. For example, the employer can temporarily fund the employee's COBRA health benefits, assuming that the employee was part of the employer's health insurance plan when he or she was terminated. With this option, the employee would continue to participate in the employer's cafeteria plan, which is allowable as long as the plan was not created predominately for the benefit of former employees.

An employer could also provide job placement services. In order for these job placement services to retain the benefits of non-cash severance benefits, the Internal Revenue Service has ruled that the employee cannot be given the choice between the job placement services and severance pay. These job placement services could be vital, especially if the former employee has been out of the job market for many years.