Employers commonly make payments to former employees for a number of reasons. Two of the more routine payments are those from a non-qualified deferred compensation plan (such as payments from a supplemental executive retirement plan or a 401(k) restoration-type plan) or pursuant to a severance arrangement, and sometimes both. (Other termination- or settlement-type payments, such as those for emotional distress or pain and suffering, are beyond the scope of this article.)
These payments may occur just once in a single sum at or shortly after termination, or the payments may be spread out in installments over the course of many months, and sometimes even years. Because these payments happen after termination, many employers and other persons (including many CPAs), tend to think that such amounts should be reported on some type of Form 1099. But as the title of this article states, that’s often wrong!
The short answer is that if the employer makes any non-qualified or severance payments to a person that are connected with or result from employee status, then such payments should be reported on Form W-2. That requirement applies regardless of when those payments are made (whether at termination or many years after). In general, such payments only belong on a Form 1099-MISC if the individual earned or became entitled to those amounts as a result of non-employee status, such as service as a non-employee director or independent contractor. To the extent someone provided service as an employee and non-employee, perhaps during different periods of time with the employer, then further analysis is needed, but the test remains the same: payments for employment belong on the W-2, and payments for non-employment, such as an independent contractor, belong on the 1099. Fortunately, such dual status happens infrequently.
The short answer here? Because the government cares. And the government cares because it wants its money, both FICA and income taxes, as soon as it can get it. If payments are incorrectly reported on a 1099, then generally no taxes are withheld, and the government must wait for the person to not only file an income tax return, but to pay the taxes due. Depending on the facts (when the payments are made and when the person files), such taxes may be delayed for nearly two years. If, however, payments are correctly treated as wages to be reported on a W-2, then withholding generally occurs as payments are made; the government gets its money, and it gets that money quickly.
To keep the government happy (and your company out of trouble), here are three practice pointers to help you stay on track.