If you’ve recently received or are negotiating a severance package, you may have encountered confusion about whether the payment should be reported on a W-2 or a 1099. Some employees have even discovered their employer issued a 1099 for severance instead of a W-2, leaving them wondering what’s correct and what they should do. This blog analyzes the legal requirements, the tax implications for employees, and whether splitting severance between W-2 and 1099 treatment is even permissible—and if so, what percentage breakdown might be beneficial.
The Clear Legal Rule: When Severance Is Purely for Wages, It Should Be on a W-2
When severance pay is compensation for job loss—essentially wage replacement—the IRS and employment tax regulations are clear: these payments are wages and must be reported on Form W-2, not Form 1099. (As discussed later, different rules may apply when a separation package includes settlement of legal claims like discrimination or harassment.) Section 31.3401(a)-1(b)(4) of the Employment Tax Regulations provides that any payments made by an employer to an employee on account of dismissal, including involuntary separation from the service of the employer, constitute wages for income tax withholding purposes.
This requirement was definitively settled by the Supreme Court in its March 25, 2014 decision in United States v. Quality Stores, Inc., which held that severance payments paid to employees who are involuntarily terminated are taxable wages for purposes of withholding FICA taxes. The Court resolved a circuit split that had existed among federal courts, confirming that severance—even for work not performed (so-called “front pay” severance)—is subject to both ordinary income and FICA taxes.
Severance pay is treated as part of your normal wages, meaning all the standard withholding that applied to your regular paycheck—including federal income tax based on your W-4, state income tax, Social Security, and Medicare taxes—will also apply to your severance payment. Jackson Hewitt similarly confirms that all severance pay is subject to federal, state, and local taxes, as well as Medicare and Social Security taxes, with these taxes typically removed from your paycheck in the form of tax withholding.
Some Employers May Try to only issue 1099s
When an employer issues a 1099 for severance, they are effectively trying to shift the full FICA tax burden onto the employee. By reporting severance on a 1099-NEC instead of a W-2, the employer avoids paying their half of Social Security (6.2%) and Medicare taxes (1.45%), making the employee responsible for the entire self-employment tax—roughly 15.3% combined.
The IRS views this as improper. According to IRS guidance, severance pay is required to be included on your W-2, and employers are required to withhold their share of FICA and Medicare taxes. Publication 15 (Circular E), the Employer’s Tax Guide, explicitly states that severance payments are wages subject to social security and Medicare taxes, federal income tax withholding, and FUTA tax.
Can Severance Be Split Between W-2 and 1099?
A split between W-2 and 1099 reporting can be legitimate in very certain circumstances—namely, when a settlement includes distinct components with different tax characteristics:
Standard severance compensation (pay in lieu of continued employment) should always be reported on a W-2. Settlement payments for non-physical injury claims arising from discrimination, harassment, or retaliation—such as emotional distress, defamation, or humiliation damages—are not considered wages and may legitimately be reported on Form 1099-MISC. Payments for physical injury or physical sickness may be excludable from income entirely under IRC Section 104(a)(2).
What the Law Says About Settlement Allocations
According to the IRS, “as a general rule, dismissal pay, severance pay, or other payments for involuntary termination of employment are wages for federal employment tax purposes”. The IRS memorandum on settlement payments makes clear that how the settlement agreement is drafted and how payments are made can impact tax liabilities on both sides.
All settlement payments regarding claims for severance pay, back pay, and front pay are wages for employment tax purposes. The Supreme Court’s Quality Stores decision confirmed that severance payments are subject to FICA taxes. Even attorneys’ fees for wage claims are themselves wages subject to employment taxes unless the settlement agreement expressly provides an allocation.
Is There an “Optimal” Split? The Reality
The question of what percentage should be higher if splitting severance between W-2 and 1099 treatment presupposes that such splitting is both legal and beneficial. Based on the sources reviewed, here’s the reality:
For standard severance (compensation for job loss), splitting is not legally permissible. Pure severance pay—whether labeled as such or structured as “front pay” or “back pay”—must be reported as W-2 wages. There is no legal basis for reporting any portion of standard severance as 1099 income to reduce tax obligations.
For settlement packages involving legal claims, the allocation should reflect the genuine nature of each claim. If your separation involves a settlement of legal claims (discrimination, harassment, wrongful termination), the portion allocated to wage-type claims (severance, back pay, front pay) should be on a W-2. The portion allocated to non-wage claims (emotional distress without physical injury, reputational harm) may potentially be reported on a 1099. However, artificially inflating the non-wage portion to reduce taxes could trigger IRS scrutiny.
Employee Preference: It Depends on What the Payment Is For
For pure severance (wage replacement), employees benefit from W-2 treatment. However, when a settlement legitimately includes non-wage damages—such as compensation for emotional distress from discrimination or harassment—the 1099 portion can actually provide significant tax advantages:
Key Government Resources
- IRS: What If I Lose My Job?
- IRS Publication 15 (Employer’s Tax Guide)
- IRS Form 8919 (Uncollected Social Security and Medicare Tax)
- IRS: Tax Implications of Settlements and Judgments
- IRC Section 104(a)(2): Personal Physical Injuries
- Supreme Court: United States v. Quality Stores, Inc.
