Guest Article

(From the March 30, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Informal Discussions with IRS Reveal Favorable Interpretation of Severance Pay Withholding Rules

Rather than paying lump sums, some employers structure severance payments as salary continuation, often basing the duration of the salary continuation on the individual's length of service. Although this approach has certain advantages, such as spreading the employer's cost over time, many payroll professionals have interpreted the IRS regulations as requiring far greater federal income tax withholding on salary continuation payments than was required when the individual received the same amounts as regular wages. Our informal conversations with the IRS, however, reveal that withholding can continue at the same rate as applied before the employee's termination.

Background

The federal income tax withholding regulations draw a distinction between "regular wages" and "supplemental wages." Treas. Reg. § 31.3402(g)-1(a)(1)(i). "Regular wages" are amounts paid for the current payroll period either at a regular periodic rate, such as hourly or daily, or at a predetermined fixed determinable amount. Treas. Reg. § 31.3402(g)-1(a)(1)(ii). All other wages are "supplemental wages." Treas. Reg. § 31.3402(g)-1(a)(1)(i). (In addition, certain types of wages are defined as supplemental wages even if they would otherwise be regular wages. Id.)

In situation 6 of Revenue Ruling 2008-29, the IRS held that severance pay is 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. This was true even if amounts were paid over a set number of weeks at a predetermined fixed determinable amount.

Once it is determined that wages are supplemental wages, the regulations impose different withholding requirements depending on whether the aggregate supplemental wages paid by the employer to the employee for the year have exceeded $1 million. Supplemental wages in excess of $1 million are subject to a mandatory flat withholding rate equal to the highest marginal tax rate (currently 35 percent). Treas. Reg. § 31.3402(g)-1(a)(2). Other supplemental wages are generally subject to the "aggregate procedure." Treas. Reg. § 31.3402(g)-1(a)(6). (The employer may be able to use an optional flat withholding rate, which is currently 25 percent, but that will result in greater withholding in most cases.)

The mechanics of the "aggregate procedure" depend on whether the supplemental wages are paid concurrently with wages for a payroll period. Treas. Reg. § 31.3402(g)-1(a)(6)(ii). If paid concurrently, those wages and the supplemental wages are aggregated, and "[i]f not paid concurrently, the supplemental wages are aggregated with the wages paid or to be paid within the same calendar year for the last preceding payroll period or for the current payroll period, if any." Id.

Applying the Aggregate Procedure to Salary Continuation Severance Payments

When an employer provides salary continuation severance benefits, many payroll professionals have interpreted the regulations as requiring every payment to be aggregated with the wages paid for the employee's last payroll period within the same calendar year. Under this interpretation, if an employee is terminated at the end of a pay period on March 20, 2009, and he receives six months of salary continuation, then each of his severance payments would have to be aggregated with his wages for the pay period ending March 20, 2009, for purposes of determining his federal income tax withholding. In effect, this doubles the wages subject to federal income tax withholding and significantly reduces the net amount of each payment the individual receives. Moreover, the total amount withheld will likely greatly exceed the individual's federal income tax liability for the year.

Through informal conversations with the IRS, we have confirmed that this interpretation is not required. Instead, the regulations can be read as providing a choice between two alternatives. The first alternative is to aggregate the supplemental wages with the wages paid or to be paid within the same calendar year for the last preceding payroll period. The second alternative is to aggregate the supplemental wages with the wages for the current payroll period, if any. Under this interpretation, if the employer chooses the second alternative, only the salary continuation payments are considered for purposes of determining the amount of federal income tax withholding, because there are no other wages in the current payroll period. As a result, the employee will be subject to the same level of withholding as applied to his regular wages while he was employed, and that amount will more closely approximate his actual federal income tax liability for the year. Moreover, it will significantly reduce the employer's or payroll administrator's administrative burden.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2009, Deloitte.