Unemployment Can Be Taxing

Unemployment can be taxing on the individuals who lose their jobs and on their families. The search for a new job and worries about how to make ends meet can take its toll. Unfortunately, unemployment can be "taxing" in another way. Unemployed individuals must grapple with unfamiliar tax rules—and they often face unexpected tax bills.

Unemployment Sticker Shock

It often comes as a shock to newly unemployed individuals that the unemployment benefits they receive are subject to income tax [IRC Sec. 85]. In effect, it seems like what the government gives with one hand it takes away with the other. And, unfortunately, this surprise often comes with a "sticker shock" in the form of an unexpected tax bill at tax return time.

Individuals who receive unemployment benefits in 2009 will get some relief. A temporary provision in the American Recovery and Reinvestment Act provides an exclusion for the first $2,400 of unemployment benefits received by an individual in 2009 [IRC Sec. 85(c)]. For married couples filing jointly the exclusion applies separately to each spouse.

However, $2,400 won't stretch very far. Moreover, the balance of any unemployment benefits received will be taxable.

Unemployment Benefits and Voluntary Withholding

Although unemployment benefits are not automatically subject to income tax withholding, benefit recipients can opt to have income tax withheld from their benefits by filing a voluntary withholding request (on Form W-4V) with the unemployment benefits office [IRC Sec. 3402(p)(2)].

States may, but are not required to, allow individuals to elect to have state and local income taxes withheld from their benefits. However, many unemployeds forgo withholding because they need every dollar of benefits to make ends meet.

Limitation to Withholding on Unemployment Benefits. Sadly, even those individuals who opt for withholding get caught short at tax time. The withholding rate is just 10%, which may not cover the full amount of tax due, especially if the unemployed had significant earnings before being laid off or income from other sources which will put them above the lowest 10% bracket.

Severance Pay and Withholding

Severance pay received from a former employer is also subject to tax since it is considered compensation for the former employee's services to the employer [Reg. §1.61-2(a)(1)]. Unlike unemployment benefits, severance pay is automatically subject to income tax withholding.

Withholding on Severance Pay Can Fall Short. However, here again, the amount withheld may or may not cover the tax due. Severance pay is treated as supplemental wages for withholding purposes. Consequently, the employer can elect to combine the severance pay with the most recent wages payment to the former employee or to withhold at a flat 25% rate.

Other Benefits

Other benefits received from a former employer may or may not be taxable.

Outplacement Services. For example, outplacement services can qualify for tax-free treatment if they are de minimis (e.g. use of a secretary to type letters or resumes or the use of the employer's telephone to contact prospective employers). On the other hand, more substantial services such as career counseling or employment agency services are tax-free only if they qualify as working condition fringe benefits.

To meet that test, the IRS says the services must be provided to the employee on the basis of need and the employer must derive a substantial business benefit (such as promoting a positive business image, maintaining employee morale, and avoiding wrongful termination lawsuits) distinct from the payment of additional wages.

Moreover, outplacement services will not qualify for tax-free treatment if the former employee can choose to receive cash or taxable benefits in place of the services. For example, if an employer's severance plan permits employees to receive outplacement services with reduced severance pay, the amount of the reduced severance pay is included in wages.

Cutting the High Tax Liability of Unemployment Benefits

On the plus side, there may be deductions available to unemployed individuals that can reduce the tax bite. However, here again, many unemployeds will be unfamiliar with the tax law rules. For example:

Job-Search Expenses

Job-search expenses are deductible as business expenses—subject to some ifs, ands, or buts. An unemployed can deduct ordinary and necessary expenses of a job search if he or she is seeking employment in a trade or business in which he or she was formerly employed and there was no lack of continuity since the last job. Expenses of looking for a job in a new line of work are not deductible. Moreover, a break between jobs—for example, to get a college degree—will KO the deduction.

Job-hunting expenses are treated as miscellaneous itemized deductions subject to the 2%-of-AGI deduction floor [Reg. §1.67-1T(a)(1)(i)]. While for some individuals the deduction floor may be insurmountable, for others the drop in income resulting from unemployment may put the deduction within reach. In that case, the key to nailing down a deduction is keeping careful track of deductible expenses, such as:

• Employment agency fees
• Job counseling and referral services.
• Resume expenses (e.g., typing, printing, and postage)
• Travel expenses to look for a new job.
• Long-distance phone calls to prospective employers.
• Subscriptions to daily newspapers with classified ads, Internet job-search sites and professional magazines and newsletters.

Example. Sarah was laid off from her job in late 2008. In early 2009, she incurred $2,500 of qualified job-hunting expenses, which eventually landed her a new job. Sarah's AGI will be $40,000 for 2009 (including unemployment compensation and pay from her n ew job). Sarah can deduct $1,700 ($2,500-$800 [2% of $40,000]) of job-hunting expenses on her 2009 tax return (plus any other miscellaneous expenses subject to the 2% floor).

Bear in mind, however, job-hunting expense deduction can be claimed only by individuals who itemized deductions. Individuals claiming the standard deduction get no tax benefit from their job-search costs.

Moving Expenses

Moving expenses, on the other hand, are deductible above-the-line in computing AGI. However, to be deductible, the expenses must be incurred in connection with a new job at a new location. The costs of moving to look for a job are not deductible if the job hunt is unsuccessful.

To qualify for a moving expenses deduction, the distance between the individual's new job and former home must be at least 50 miles further then the distance from between the old job and the former home. In addition, the individual must work as an employee at the new job location for at least 39 weeks in the 12 months following the move.

Education Expenses

Education expenses can generate tax deductions or tax credits when a client is laid off. For example, suppose an unemployed individual takes a brush-up course to improve his or her job skills. Depending on the type of course and the individual's tax situation, the costs of the course may be deductible above-the-line as a higher education expense [IRC Sec. 222] or as an itemized employee business expense (subject to the 2% deduction floor). Alternatively, the individual may be able to claim a Lifetime Learning credit [IRC Sec. 25A].

Conclusion

Ideally, just as soon as they are let go, unemployed individuals should begin planning to reduce the taxes they will owe come tax return time.

This advance tax planning will involve both a projection of taxable income and of deductible expenses, as well as a plan for pre-payment of the anticipated tax liability through withholding and/or estimated tax payments. And to do that, they may need your professional guidance in dealing with the unfamiliar and often-complex tax rules involved. (See the accompanying box for practice tips on dealing with the unemployment crisis.)