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Employment Law: Is Severance Pay Taxable?

Is severance pay taxable? Yes, which is why it is essential to review how a potential settlement can be allocated lawfully to maximize settlement dollars when negotiating a severance settlement and save tax on severance pay. This process helps finalize a settlement, resolve the case and determine how much of the settlement clients can retain to help save tax on severance pay.

To expand on the question, ‘Is severance pay taxable?’  we outline some allocation options that can be applied favourably below:

Severance Pay Is Taxable: How To Save Tax Through Allocation

Settlements allocated as general damages can be tax-free. A client can allocate a portion of the settlement as general damages outside of damages claimed by a dismissed employee’s employment severance pay. Usually, this means claiming human rights damages or damages for injury to dignity, feelings and self-respect.

An employer may choose to allocate a portion of the entire settlement as general damages during negotiations to help save tax on severance pay. It is crucial to use relevant case law to guide what to offer during severance pay negotiations. 

How To Allocate A Settlement To A Retiring Allowance

Under section 248(1) of the Income Tax Act (“ITA”), a retirement allowance is an:

 An amount (other than a superannuation or pension benefit, an amount received as a consequence of the death of an employee or a benefit described in subparagraph 6(1)(a)(iv) [of the Income Tax Act]) received

     (a) on or after retirement of a taxpayer from an office or employment in recognition of the taxpayer’s long service, or

     (b) in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal, by the taxpayer or, after the taxpayer’s death, by a dependant or a relation of the taxpayer or by the legal representative of the taxpayer.”

According to section 248(1) of the ITA, a retiring allowance intends to compensate an employee for the loss of their employment or their long tenure with the company. 

Since severance pay is taxable, some may differ all or some of it to a retiring allowance. Because of tax treatment, a retiring allowance is different from other allocations like general damages or reasonable notice damages. For example, reasonable notice damages are regularly taxed, meaning there would be deductions for income tax, CPP, and EI. On the other hand, a retiring allowance can also be subject to taxes, but at a lower rate, depending on the amount.

Lastly, another way to defer tax is to transfer the settlement payment from the employer directly into the employee’s RRSP to save tax on the severance pay. In this case, funds will only get taxed at the withdrawal time.

How to Allocate Settlement Toward Legal Fees

Putting a portion of the settlement towards legal fees is another way to save tax on severance pay because legal fees are typically tax-deductible. Generally, an invoice would need to be provided during settlement, demonstrating that relevant fees are paid. 

Conclusion

Although severance pay is taxable, an experienced employment lawyer has several methods of allocating costs to lawfully save tax on severance pay, including what is highlighted above. Although we recommend working with a lawyer when negotiating any settlement we also recommend consulting a financial advisor or accountant before finalizing it.

Contact Us

Whether you are an employer or an employee looking for assistance with workplace issues, disputes or employment relationships, our team of experienced employment lawyers at Achkar Law can help. Contact us by phone toll-free at +1 (800) 771-7882 or email us at [email protected], and we would be happy to assist.

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Disclaimer: This blog is not intended to serve as or should be construed as legal advice and is only to provide general information. It is in no way particular to your case and should not be relied on in any way. No portion or use of this blog will establish a lawyer-client relationship with the author or any related party. Should you require legal advice for your particular situation, fill out the contact form, call (800) 771-7882 or email [email protected]