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Severance pay and taxation

Not anticipating federal tax consequences often leads to problems for Michigan taxpayers. To the IRS, even severance pay is subject to taxation. It matters little to the agency whether such severance pay is due to a firing, layoff, or settlement of a lawsuit.

As it concerns payment after an employee rendered services, some may refer to severance pay as gap pay. The amount of severance pay could be a result of federal or state law, company policy, or some sort of agreement.

However the severance pay came about, the IRS may still rule it as subject to tax. Severance pay generally receives the same tax treatment as wages. So in the event of a lawsuit settled a number of years after leaving your job, the severance check you receive as part of the lawsuit may still be less due to withholding of taxes.

The law concerning treatment of severance pay from an employer can be complex. And it concerns more than simple withholding of taxes. Severance pay is subject to employment taxation, withholding and other payroll deductions.

Yet whether the entire amount of the severance pay should be subject to employment taxes is a matter of great controversy. As the employer and employee each pay half the amount to the employment taxes, this can prove expensive for employees.

The U.S. Supreme Court addressed this question in 2014. While in theory, severance pay is for services never rendered, the court sided with the IRS in stating that any amount of severance pay can receive employment tax treatment.

This illustrates why tax planning is important. It is important because no one wants to discover too late that they owe taxes. Unpaid taxes can lead to seizure of assets, tax audits, and even criminal penalties. An experienced tax lawyer can prevent such unpleasant surprises from occurring.

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