Although most states conform to the federal tax treatment of severance pay, a handful of states have differing regulations.
Under the Internal Revenue Code, employer payments to employees made as the result of an involuntary termination are wages subject to federal income tax withholding, FICA, and FUTA. This provision includes payments made in lieu of notice of termination, as well as dismissal payments required by law or contract. Lump-sum payments should be treated as supplemental wage payments. Severance payments made following early termination of an employment contract are considered taxable wages.
North Carolina was among the states that did not follow the federal treatment, but as of Jan. 1, 2014, it conforms. Prior to Jan. 1, the state offered a subtraction modification for the first $35,000 of a severance payment.
Alabama allows the first $25,000 of a severance payment to be exempt from state income tax withholding. For a severance payment to be exempt, employees who lose their jobs as a result of “administrative downsizing” can be exempted from paying income tax on the first $25,000 of severance pay. Severance pay includes unemployment compensation, termination pay or income from a supplemental income plan. Employers must apply for approval to exempt the severance payments.
Although Oregon conforms to the federal treatment of severance pay, it gives a one-time subtraction if the severance pay is invested into a new or existing small business.
Most states tax severance payments made to nonresidents for services performed in state, but a few differ. For example, the District of Columbia and Georgia tax severance payments made to residents, but those made to nonresidents are exempt from withholding.
California taxes severance payments made to nonresidents unless the payment is made under a plan telling the employee what is to be received at termination.
For more information, see Payroll Administration Guide.
By Allison M. Gatrone
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