Employers often face tough staffing choices. If you decide to let someone go because of budget cuts, restructuring or other circumstances, offering severance may seem like the right thing to do. It can offer the individual some temporary financial support while helping you manage a difficult transition. But such payments can also create unexpected costs and administrative responsibilities, so you should never make the decision impulsively.
Consider the strategy
Why offer severance? For many employers, the answer goes beyond simply wanting to help certain employees transition out of the organization. Thoughtfully designed severance agreements can support an attractive hiring package. In the event they’re actually used, these arrangements can demonstrate consistency when eliminating positions and allow you to better predict the costs of those departures.
The trick is balancing generosity with affordability. Severance may seem perfectly reasonable in good times. But it can become burdensome during a financial downturn or when staffing cuts are needed for another reason — the very circumstances under which it may be most likely used.
Craft careful language
Generally, federal law doesn’t mandate severance, though state laws may impose some requirements. And indeed, such payments may be out of budgetary reach for some small and midsize employers.
If you decide to offer severance, clearly establish and document the terms. An agreement must set unambiguous expectations for both parties. It might provide for a lump-sum payment, weekly or monthly payments, or other benefits. The language may be embedded in a staff member’s original employment contract, in a separate standing plan or in an individual severance agreement developed just before termination.
Before making any such commitment, estimate the total cost of the payment and determine how it would affect your organization’s near-term financial performance — particularly its cash flow. Work with your attorney to develop the language. If you already have one or more severance plans in place, occasionally review them so you’re not caught off-guard by their financial implications should you decide to let the applicable party go.
Anticipate payroll taxes
Severance generally constitutes taxable wages. That means it’s subject to federal income tax withholding as well as Social Security and Medicare taxes. Employers must pay their share of applicable employment taxes, including federal unemployment tax.
For federal income tax withholding purposes, severance is generally treated as supplemental wages. Depending on the circumstances and how the payment is made, you may be able to use the optional flat 22% withholding rate or the aggregate method. (Ask your tax advisor for help.) Special rules apply when an employee’s supplemental wages exceed $1 million during the calendar year.
Departing employees may be confused by the tax impact of severance. The amount withheld from a payment won’t necessarily cover the individual’s total income tax liability. To smooth the transition, train HR staff to explain that the amount withheld isn’t necessarily the employee’s ultimate tax obligation, and that individual circumstances can differ. Just be sure to warn them against giving specific tax advice.
Think beyond the payment
The face value of a severance payment is often only one component of the total cost of an employee’s departure. Depending on the arrangement and applicable law, you may also need to account for:
- Accrued vacation or other paid leave,
- Continuation of certain employee benefits, and
- Administrative or professional fees associated with the departure.
Timing matters, too. A lump-sum severance payment may be substantial, but it concentrates the cash outlay in one period. Installment payments spread that burden over time; however, they extend payroll administration and require you to plan for those future obligations. Either approach can affect cash-flow forecasts — particularly if multiple employees are departing.
Last, it’s important to distinguish severance from unemployment benefits. Eligibility for unemployment compensation and the effect of severance payments on those benefits generally depend on state law. Don’t assume that providing severance will eliminate an unemployment claim — or prevent a claim from potentially affecting future state unemployment tax costs.
Total impact
Severance can be a useful workforce management tool, but it represents a commitment with considerable financial consequences. When establishing or reviewing your approach — and certainly when making an offer — look beyond the initial dollar amount and calculate the total impact. We can help you analyze the tax and cash-flow implications and determine whether severance fits into your organization’s budget and strategic plans.
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We highly recommend you confer with your Miller Kaplan advisor to understand your specific situation and how this may impact you.
