Severance payments in the context of employment relationships touch upon labor law, social security law and income tax law. The following is primarily concerned with the wage tax treatment of these special payments, which are exempt from social security contributions insofar as they are paid as compensation upon termination of the employment relationship. But severance pay can have an impact on the payment of wage replacement benefits.
What is severance pay??
Under income tax law, severance payments are compensation payments. They are usually paid to compensate the employee for disadvantages arising for him or her from the termination of an employment relationship. As a rule, they are paid as compensation for the loss of a job. However, other case constellations are also conceivable, such as the payment of a severance payment on the occasion of the reduction of the weekly working hours in accordance with the contract. Severance pay is also paid to compensate for non-material damages incurred by the employee in the employment relationship or during the initiation of such a relationship, for example, due to discrimination. The tax liability depends on the type of severance payment. Therefore, for each severance payment, it must first be examined what type of compensation payment it is.
Who must calculate and pay any income tax due on the severance payment??
The obligation lies with the previous employer. He has to prepare the corresponding (wage) statement when paying out the severance payments. The employer then pays the calculated wage tax to the company tax office as usual.
Checklist for calculating payroll taxes on a severance package
1. What type of severance payment is involved?
a) severance payments in the event of dismissal from the employment relationship
Labor law provides for compensation payments in the event of dismissal only in special cases; § 1a of the Dismissal Protection Act regulates this in more detail. In addition, social plans also frequently stipulate such severance payments. Severance payments made on the occasion of dismissal to compensate for disadvantages such as the loss of the job are in principle taxable wages.
b) Severance payments according to § 15 para. 1 General Equal Treatment Act (AGG)
If the employer violates the prohibition of discrimination, he is obliged to compensate the affected person for the resulting damage, insofar as he is responsible for the breach of duty. This compensation payment is also taxable wages because it is paid as compensation for lost profits.
c) Severance payments pursuant to § 15 para. 2 AGG
Here, immaterial damages resulting from the disadvantage of an employee, for example, due to discrimination or mobbing, are compensated. This severance pay is not regarded as income from the employment relationship and is therefore not taxable wages and salaries.
Severance payments relevant under wage tax law are compensation payments that the employee receives as compensation for the disadvantages associated with the termination of the employment relationship, in particular for the loss of the job. These severance payments are wages subject to wage tax, which can be taxed according to the one-fifth rule.
2. Is it a severance payment made in the private sector or one made in special areas of the public sector?
While private sector compensation payments are taxable without exception, some lump-sum "civil service" compensation payments are exempt from taxation. Examples are the following severance payments:
– the lump-sum compensation according to §§ 28 – 35 of the Soldiers’ Compensation Act (Soldatenversorgungsgesetz)
– the compensation payments according to § 48 Abs. 1 BeamtVG
– the one-time amount according to § 77 of the Soldiers’ Pensions Act
– Compensation payments in accordance with Section 38 of the Soldiers’ Pensions Act
3. Can the severance payment be taxed at a reduced rate under the one-fifth rule??
If it has been determined that it is a taxable severance payment, this other benefit can be taxed at a reduced rate via the so-called quintuple rule. The background to this is that a severance payment significantly increases the employee’s taxable income in the year of payment. This also massively increases the tax rate of the person concerned. In order to mitigate this harsh tax progression, § 34 para.1 sentence 1, 2 Income Tax Act (EStG) in the area of extraordinary income a tax privilege for employees. The prerequisite for this is that the severance payment made to him represents a compensation payment. In this context, the law in § 24 no.1.a) EStG of a " compensation for lost or foregone income."
Here it must always be examined in the individual case whether it concerns such a compensation payment. It is important that the job does not necessarily have to be eliminated. As already described at the beginning, such privileged extraordinary income can also be seen, for example, in the case of reduced hours and similar constellations as compensation for lost income.
Even inventor compensation has already been considered as a tax-advantaged compensation benefit. (Cf. Ruling of the BFH of 29.02.2012 to the file number IX R 28/11.)
It is also very important that the compensation payment accrues in a single assessment period, because only then can the unfair tax progression be reckoned with. If, on the other hand, the payment is spread over several assessment periods, the application of the one-fifth rule is usually ruled out. Exceptions have been allowed by the Federal Fiscal Court for cases in which supplementary compensation payments have been made in later assessment periods out of social welfare. (Cf. this is the case law of the BFH from the rulings of 14. August 2001 to the reference number XI R 22/00 as well as of the 24. January 2002 on the case number XI R 43/99.)
4. Does the application of the Funftelregelung lead to a lower income tax than the regular taxation?
The quintuple regulation is a "more favorable examination. Only if its use makes the person concerned better off from a wage tax point of view, it may be applied. The regulation may defeat its purpose, especially in the case of very high incomes. In detail, the following calculation is performed:
The severance payment is divided by five. The calculated fifth is then added to the rest of the annual income. From this sum once the tax is computed, which results from the summed up yearly income increased by the fifth. On the other hand, the lower tax is determined that would result without a compensation payment. The latter amount is deducted from the former. The resulting difference is multiplied by 5 and thus yields the tax amount on the compensation payment according to the fifths regulation.
If this amount is lower compared to the tax due on the full taxation of the summed amounts from regular income and severance pay, it is used as a basis for the wage tax settlement.
Important: According to § 39b para. 3 sentence 6 EStG, the severance payment is to be reduced by the pension allowance and the old-age relief amount as other remuneration. This is true if the requirements for the deduction of these amounts are met and if they were not previously taken into account in the calculation of the tax for the annual salary.