How does a lump-sum severance payment affect unemployment benefits versus payments spread out over a few pay periods? What are the tax implications?

The impact of severance payments on unemployment benefits will depend on three factors: the state regulation governing unemployment benefits, the manner in which payments are made and the definition of severance as applied to the payments.

First of all, state unemployment regulations will generally determine how such payments will affect an employee’s eligibility for unemployment. Severance payments under some state regulations will have no impact on an employee’s benefits, whereas in other states, severance payments will either delay or reduce the unemployment benefits an employee will receive.

The type of payment received will also have an impact on the unemployment benefits. Severance payments made to an employee in exchange for a release of claims or in recognition for past service may either delay the receipt of benefits or have no impact at all. On the other hand, payments made as salary continuation assigned to a specified period of time or in lieu of notice will likely delay or reduce the unemployment benefits that the employee will receive.

Another factor to consider is whether the severance payment is unilaterally offered as part of company policy. In such a circumstance, these payments may disqualify an employee from unemployment. However, if severance is negotiated on a case-by-case basis, it would likely not affect eligibility for unemployment.

From a tax perspective, the IRS views traditional severance payments as supplemental wages because they are not a payment for services. Severance paid to employees in a lump sum, unrelated to state unemployment benefits, is taxable as wages for both income-tax withholding and FICA purposes.

Therefore, the employer may choose to use either the optional flat rate withholding or to use the aggregate method. Using the aggregate method, the employer would add the supplemental wages to regular wages and calculate the total amount as regular wages. From an employee's perspective, it may be beneficial to receive the payments up front if an employee is able to direct them into a tax-favored investment such as an IRA. 

Employers should review the state unemployment regulations to determine the impact their severance payments may have on employee unemployment eligibility. If they do not affect eligibility, then it may be more cost beneficial to make these payment in a lump sum rather than incurring a processing fee over several additional pay periods.