Payroll Deductions From Severance Pay: What the Law Allows
written by: N Nayab•edited by: Jean Scheid•updated: 5/20/2011
Severance pay is payment an employee receives when they leave employment of a company, owing to layoffs, job elimination, mutual agreement to part ways, or other reasons. Read on to find out the laws regarding payroll deductions from severance pay.
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The definition of severance pay includes any regular pay due to the employee, payment for unused vacation time or sick leave, retirement benefits, and other benefits, besides additional payment of usually a week or two’s pay for every year of service.
The Fair Labor Standards Act (FLSA) law only mandates employers to pay to the employee leaving employment for any reason any wages due to the employee through the last day of work, including any overtime, bonuses, commissions, reimbursement of expenses, and payments for unused vacation time. Most states require the employer to release final pay to the employee either immediately or within a specified time.
The law does not mandate the employer to make any additional severance payment, or wages for unused sick leave, unless the company policy or employment contract specifies such payment. Severance pay in such cases are part of benefits available to the employee, and once voluntarily established, fall under the Employee Retirement Income Security Act of 1974 (ERISA) that requires employers to establish and maintain such plans with equity and accountability.
The Worker Adjustment and Retraining Notifications (WARN) Act requires covered employers who lays off employees without providing the mandatory 60 days notice, except under unforeseen circumstances, to provide back pay and benefits for the period during which the employer violates WARN Act. Any wages or unconditional payments paid to the employee during such period, including any severance pay may be deducted from such WARN act payouts.
The major payroll deduction from severance pay is taxes.
The Internal Revenue Servide (IRS) treats any severance pay as “supplemental wages" and requires employers to deduct payroll taxes from such wages. The law also requires employers to withhold other appropriate federal and state taxes, such as income tax based on any exemptions or limitations that may vary from state to state.
A Michigan district court has held that severance pay is not subject to Federal Insurance Contributions Tax (FICA) taxes.
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Another major payroll deduction from severance pay is benefits. An employer can deduct from severance pay insurance premiums for the term already covered or for the completion of the term.
Case laws uphold deducting from employees severance payments to pay for cafeteria plan benefits that a terminated employee enjoys for an extended time following the date of termination. The law regards a terminated employee as an “employee" in continuing employee-participant schemes of employer-funded accident or health insurance plans.
COBRA is a federal act that requires employers with 20 plus employees and who provide group health insurance benefits to offer extended health insurance benefits at group rates to departing employees in certain situations such as layoffs. The employee has the option to avail of such coverage, in which case the employer makes a deduction of the employee contribution from the severance package. The employer may also opt to subsidize COBRA coverage for a limited time as part of a severance package.
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Garnishment and Child Support
The law allows garnishments of severance pay to be processed by payroll. When severance pay relates to pay for the period worked, the exempt amount from garnishment bases itself on such period, and if the severance pay is a lump sum not related to the period worked, the exemption stipulations for one pay period applies. If the employee receives both wages for last period worked and additional severance payment in a single paycheck, the employee gets the exempt amount only once.
The law requires employers to withhold from severance pay any child support payment normally deducted from the employee’s payroll. Such deductions are based on the proportion of deductions from normal wages, just as making deductions from a normal paycheck.
So how does an employer calculate severance pay? Payroll deductions from severance pay include applicable taxes, child support, garnishments, and extended benefits from the amount offered per company policy. Next, deduct any amount due to the employer such as outstanding loans or advances.
Any severance payment made by the employer is, strictly speaking, goodwill extended by the employer to the departing employee. The employers remain at liberty to subtract any amount such as loans or advances that the employee owes the company from a severance pay check. If the severance agreement or contract specifies withholding of only taxes from the severance pay, then the employee can technically file a suit for breach of that agreement, but the courts need not entertain such a suit.
If the employer makes severance pay without any contract or agreement, the employer has the right to withhold a part or all of such payment if the employee refuses to sign a severance agreement that may include conditions such as a waiver of rights to approach the courts for additional compensation. Requiring older employees to waive their rights to sue the employer for age discrimination requires compliance with the Older Workers Benefit Protection Act (OWBPA).
The employer cannot, however, force an employee to sign a severance agreement, or withhold money already earned by the employee even if the employee refuses to sign such a severance agreement.