Payroll in Practice: 3.24.2025

Question: An employer plans to pay an employee six months of severance in a lump sum with the final paycheck. The usual pay period is semimonthly. May the withholding be computed as if the severance pay were paid over 12 semimonthly pay periods?

Answer: It might seem reasonable to compute the withholding on a lump sum severance payment as if it were paid over the pay periods it is intended to cover. Federal regulations provide an option to treat vacation pay as paid over the period covered by an advance payment for withholding purposes, but this option cannot be used if any regular pay is also paid to the employee during that period. In such cases, the supplemental pay rules will apply to the lump-sum vacation payment.

There is no similar exception for severance pay. The withholding for the severance pay must be computed as based on the single semimonthly pay period when the payment is made. If an employee’s cumulative supplemental pay exceeds $1 million during the calendar year, the mandatory flat withholding rate of 37% applies to any cumulative supplemental pay exceeding the $1 million threshold. For any amount subject to the mandatory flat rate, the total amount withheld is not affected by the pay periods.

Similarly, if the employer uses the optional flat 22% withholding rate for the supplemental pay that is not subject to the mandatory flat rate, the amount withheld will be the same regardless of the pay periods. The optional flat-rate method may be used when two requirements are met. First, income tax must have been withheld from the employee’s regular pay at some point during the current or immediately preceding calendar year. Second, the supplemental pay must be distinguished from the regular pay for the pay period, either by making a separate payment or by stating the supplemental pay separately in the employer’s records.

If the mandatory flat rate does not apply to the payment and the optional flat-rate method is not used, the employer should use the aggregate method to compute the withholding on the supplemental wages.

Generally, under the aggregate method, the supplemental pay is combined with other wage payments made during the pay period. Withholding is then calculated on the aggregate amount using either the percentage or wage bracket methods. The amount to withhold from the severance pay is the total withholding on the aggregate amount minus any amounts withheld from other wage payments made during the same pay period.

A closer approximation of the employee’s actual tax liability may be achieved by using one of the alternative withholding methods described in IRS Publication 15-T, Federal Income Tax Withholding Methods.

The cumulative-wage method seems to be the most appropriate for this situation. However, an employer may only use this method upon the employee’s written request, and the employer must have paid the employee using the same pay frequency since the start of the year. The employee’s request does not obligate the employer to use the method.

Since the final pay, including the severance pay, is the final payment the employer makes to that employee, it should meet the conditions mentioned by the IRS in in Private Letter Ruling 200505004, which says that an alternative method is only allowed when used as a comprehensive method for withholding on all of an employee’s wages. An employer cannot apply the alternative method to only a portion of the employee’s wages and apply a different method to another portion.

To calculate the withholding using this method, first add the wages already paid to the employee during the current calendar year to the wages for the current pay period. This includes severance pay and any other compensation, such as accrued paid time off, that the employee receives in the current pay period.

Next, divide the employee’s total compensation for the year-to-date, including the current pay period, by the number of pay periods that have occurred in the calendar year, including the current one. This gives the average pay per pay period for the current year.

The appropriate percentage method worksheet and tax table from Publication 15-T should be used to compute the withholding on the average wage per pay period. First, the average withholding is multiplied by the number of year-to-date payroll periods to determine the withholding on the total cumulative compensation. Then, income tax previously withheld during the calendar year is subtracted from the total calculated withholding. The resulting difference is the amount to withhold from the final payment.

If the employer makes any additional payments during the calendar year, the employer should use the cumulative wage method to compute the withholding for those payments as well.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information
Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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