Severance pay for job loss: how to calculate the tax

An employee must leave. It’s not nice, but sometimes it can’t be avoided. You don’t have to, but as a compassionate employer you give him a nice severance payment. Or because you can shorten a legal dispute this way. But have you considered the tax?

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As an employer, do you have to compensate a departing employee?

There is no legally defined right to do so. But as an employer, you can award an employee severance pay. For example, if he loses his job due to circumstances. Basis for this can be Agreements be between you, which you have taken with foresight for the case of the termination of the employment relationship. Or you were in dispute in court, it came to a conciliation agreement on a financial compensation for social hardship to shorten the duration of the dispute.

Is tax then due on such a severance payment?

Yes, in principle it is subject to income tax in full for your employee. This means that you, as the employer, deduct these amounts for payroll taxes when you pay your wages and remit them to your tax office. This was not always the case. Until 2006, a terminated employee was entitled to a tax-free amount of 7 % on a severance payment.200 euros. This was stipulated in § 3 no. 9 of the German Income Tax Act (EStG). This ceased to apply at the time.

Tip of the editors

This article is based on articles from the "Wage and salary pro AKTUELL" (Expenses 09 and 10/2019).

Our advice letter "Lohn und Gehaltsprofi AKTUELL" (Wage and Salary Professional CURRENT) informs you on a monthly basis about all new developments in the area of wages& Payroll accounting – practical, compact and with concrete recommendations for action. With legally sound information and job aids for optimal salary management.

How high can such a severance pay be?

Depending on duration of the terminated employment relationship is more than twice as high as the regular annual remuneration. Usually, you will award your employee half a month’s salary as severance pay for each year of his or her service with the company. This in turn leads to a disproportionately high annual income tax burden for him.

How can this burden be mitigated?

Due to the Fifth regulation. What it regulates is stated in § 34 para. 1 sentence 2 EStG. It is intended to mitigate the extreme additional tax burden resulting from payment of a severance payment. For such extreme cases, it provides for a tax reduction on the severance pay paid.

How to calculate the tax reduction on the severance pay paid?

• First divide – divide – the severance pay by 5. You then add the result – the quotient – to the taxable annual remuneration. The sum, amount A, is the starting figure for calculating your income tax.
• Now determine the income tax payable that would be due on the pure taxable annual salary without severance pay – amount B. The difference between amount A and amount B is the amount that would result if you had paid out only one fifth of the severance pay to your employee.
• Now, however, you have granted your employee the severance pay in one sum. Therefore, you now multiply the additional tax burden, i.e. the difference between amount A and amount B, by 5. The resulting amount as a product of this, the severance pay thus burdens your employee less for tax purposes.

A tip for church taxpayers: Upon request, some churches waive up to 50 percent of the church tax due on the severance pay paid, even if there is no legal basis for this. You can formulate the application for refund informally and send it together with a copy of the income tax assessment notice to the responsible church tax office.

Let’s assume you have a company in North Rhine-Westphalia and had to dismiss an employee. She has tax class 4, is a Roman Catholic, and with one child to consider, has a gross annual salary of 45.600 Euro. Since she has to leave your company, you as her employer pay a severance payment of 10.000 euros.

Applying the one-fifth rule results in the following tax settlement for the severance payment:

If the severance payment paid is taxed as other remuneration, this calculation results:

In this case, your employee will therefore receive more after the tax treatment as other remuneration than if the quintile regulation were applied. So here you carry out the tax to be withheld due to the treatment as other remuneration.

Then the settlement is more favorable as a miscellaneous purchase?

Not always. So possibly not to the desired extent if your employee, whom you had to terminate, has a very high annual salary and the severance pay granted is also above average. In these cases, it may be worthwhile to spread the payment of the severance pay over several years.

But even otherwise, the five-percent rule can be more advantageous for your employee. To illustrate this with a practical example, let’s assume again that an employee to whom you are giving notice has a gross annual salary of 30.000 Euro refers. You as his employer pay him 5.000 Euro severance pay. Your employee is subject to tax class 3 and has no eligible children. All other details remain as in our first assumption above.

Let us first calculate again according to the quintuple regulation. Then the following calculation results:

And now we calculate again the paid severance pay as a miscellaneous payment. Then the calculation is as follows:

The calculation according to the quintuple regulation costs your employee 9.16 euros more – an albeit small advantage, this regulation is therefore mandatory to apply.

As we can see, this entails a certain degree of uncertainty for your employee. Therefore he should always carry out a calculation in advance or have it carried out, when a severance payment is due because of the loss of the job. This is the best way for him to determine the more favorable wage taxation for him.