US Tax Return Preparation for Expats: UK Severance Pay

The UK's £30,000 termination payment exemption has no United States equivalent. For a US citizen or green card holder who exited a UK role under a settlement agreement, the entire package — exempt slice included — is gross income on Form 1040. Sound US tax return preparation for expats therefore begins by re-characterising and re-sourcing every line of that agreement before a single foreign tax credit is claimed.

This is one of the most expensive blind spots we see at Jungle Tax. A senior executive negotiates hard on the UK numbers, signs the agreement, watches PAYE settle the taxable balance, and reasonably concludes the matter is closed. It is closed in Britain. It is wide open in America — and if the US returns were never filed in the first place, the severance year is usually the year that forces the whole history into the light.

Why did HMRC tax only part of my settlement while the IRS wants to tax all of it?

Because the two systems are answering different questions. HMRC asks what the payment is under UK statute: earnings, a termination award, a restrictive covenant payment, or something else. Each label carries its own charging provision, and one specific relief — the £30,000 exemption in section 403 of the Income Tax (Earnings and Pensions) Act 2003 — removes a slice of genuine compensation for loss of office from charge entirely.

The Internal Revenue Code asks a blunter question: did you receive an accession to wealth, clearly realised, over which you have complete dominion? Severance almost always answers yes. There is no Code section that mirrors section 403, no de minimis band for compensation for loss of office, and no relief that turns on a foreign statute having exempted the money. A UK exemption is simply a fact about how much UK tax was paid — nothing more. It changes your foreign tax credit arithmetic; it does not change your US gross income.

The practical consequence is uncomfortable and predictable: the most tax-efficient slice of your UK package is the slice with the least UK tax available to credit against it, so the residual US liability concentrates precisely where you thought you had won.

How a UK settlement agreement is built — and why the US ignores the labels

UK settlement agreements are drafted to a fairly standard architecture, and the ordering matters enormously because the £30,000 exemption is applied last, to what survives.

The UK sequence: PENP first, exemption second

Since 6 April 2018, employers must calculate Post-Employment Notice Pay (PENP) before anything else. PENP is a statutory formula that identifies the portion of a termination package attributable to notice the employee did not work. Whatever the formula produces is taxed as general earnings — full income tax and Class 1 National Insurance — and cannot touch the £30,000 exemption. Only the relevant termination award that remains after PENP has been stripped out can qualify.

Contractual payments in lieu of notice, accrued but untaken holiday, unpaid salary, contractual bonuses and any payment for entering restrictive covenants are all earnings in the ordinary way and never enter the exempt band. Statutory redundancy pay, enhanced redundancy, genuine ex gratia compensation for loss of office and most damages for wrongful dismissal do enter it — and are exempt up to £30,000, with the excess subject to income tax and, since 6 April 2020, employer Class 1A National Insurance. HMRC's own analysis of the charging hierarchy sits in the Employment Income Manual at EIM13000, which is explicit that section 401 applies only where a payment cannot be charged to income tax in any other way.

The US does not recognise any of these categories

None of the UK labels survive the crossing. The IRS does not care whether a payment was a "relevant termination award" or a PENP figure; it cares whether the payment is compensation for services (wages), damages excludible under a specific Code provision, or something else entirely. In practice almost every element of a UK exit package lands in ordinary income.

Component of the UK package	UK / HMRC treatment	US / IRS treatment on Form 1040
Unpaid salary, accrued holiday, contractual bonus	General earnings; PAYE and Class 1 NIC	Ordinary compensation income; wages
PILON / Post-Employment Notice Pay	General earnings; excluded from the £30,000 band	Ordinary compensation income; wages
Statutory redundancy pay	Relevant termination award; within the £30,000 band	Fully taxable ordinary income — no exemption
Ex gratia compensation for loss of office	First £30,000 exempt; balance taxed, employer Class 1A on excess	Fully taxable ordinary income — no exemption
Payment for restrictive covenants	Always taxable earnings; never within the exemption	Ordinary income; sourcing analysis differs from wages
Injury to feelings / discrimination element	Termination-related awards generally taxable	Taxable unless attributable to physical injury or sickness
Employer legal fee contribution paid to your solicitor	Usually exempt where limited to advice on the agreement	Generally includible; deduction depends on the claim type
Outplacement / career counselling	Statutorily exempt in defined circumstances	Fringe benefit analysis; frequently includible
Accelerated share awards on exit	Earnings at vest; apportioned by relevant period	Ordinary income at vest; workday-sourced
Employer pension contribution into the exit deal	Generally not taxable if within annual allowance	Taxable to a US citizen absent a treaty position

What does the £30,000 exemption actually cover in 2026?

The exemption is narrower than most departing executives believe, and it has been narrowed further over the past several years. It applies once per employment (and to associated employments, aggregated), it is a lifetime-per-employment figure rather than an annual allowance, and it has not been uprated for inflation in a very long time — which means it now shelters a rapidly shrinking share of a senior package. GOV.UK's consumer-facing guidance confirms the headline position that statutory redundancy pay under £30,000 is not taxable, but the headline conceals the sequencing that determines what actually reaches the band.

Two further points matter for internationally mobile executives. First, Foreign Service Relief — which historically reduced the taxable portion of a termination award by reference to periods of overseas service — was restricted from 6 April 2018 and is now generally available only to individuals who are not UK resident in the year of termination. A UK-resident executive with a long foreign assignment history can no longer lean on it and must rely on treaty relief instead. Second, the exemption operates on the award, not on the person: it is indifferent to your citizenship, so an American executive and a British colleague with identical packages receive identical UK treatment and radically different global outcomes.

How does the IRS characterise UK severance pay?

Characterisation is the first substantive step in the US return, and it drives everything downstream — the exclusion analysis, the sourcing analysis, the credit basket and, if there is a discrimination claim in the mix, the deductibility of your legal fees.

The physical injury trap

US law excludes from gross income damages received on account of personal physical injuries or physical sickness. It does not exclude damages for emotional distress, reputational harm, or injury to feelings unless those flow from a physical injury. UK settlement agreements frequently carve out an "injury to feelings" sum in a discrimination context, and clients often assume that a payment their UK adviser treated favourably will be treated favourably in America. It will not. Absent a documented physical injury or sickness, that element is ordinary US income, and the burden of substantiating any exclusion sits squarely with the taxpayer.

Restrictive covenant payments

The sum paid for non-compete and non-solicit undertakings is always taxable in the UK. For US purposes it is ordinary income too, but it is conceptually a payment for forbearance rather than for services rendered — and that distinction can push its source away from the workday-based analysis you apply to the rest of the package. Where the covenant restrains activity in a defined territory, the sourcing position needs to be reasoned and documented rather than assumed. This is precisely the kind of line item that generalist preparers roll into "wages" without a second thought.

Legal fees

Where an employer pays your solicitor directly for advice on the settlement agreement, the UK exemption is usually straightforward. The US analysis is not. The payment is generally includible in your income, and whether you get a deduction depends on the underlying claim: fees attributable to a claim of unlawful discrimination can qualify for an above-the-line deduction under a specific Code provision, whereas fees attributable to an ordinary contractual dispute fall into the miscellaneous itemised deduction category that is now disallowed. Two identical invoices can therefore produce very different net results depending on how the claims are pleaded in the recitals of the agreement. It is worth reading those recitals before you sign.

Does the Foreign Earned Income Exclusion cover UK severance?

Sometimes — and the timing rule is the reason most executives are disappointed.

Severance can qualify as foreign earned income where it compensates for services performed outside the United States. But the exclusion carries a hard cut-off that has nothing to do with the character of the payment: amounts received after the end of the tax year following the tax year in which the services were performed are not foreign earned income at all. The IRS states this plainly in its guidance on what counts as foreign earned income.

For a settlement paid promptly after a December or January exit, this is usually navigable. For a package negotiated over eighteen months, paid in instalments, or settled after litigation, large tranches routinely fall outside the definition entirely. And even where the payment does qualify, the exclusion is capped at an annually indexed figure that a senior severance package will exhaust in its opening line. The exclusion is a partial answer at best; the foreign tax credit is the real machinery.

There is also a structural trap. Form 2555 requires you to qualify under the bona fide residence test or the physical presence test for the year of receipt. An executive who leaves the UK role and relocates — to the United States, or to a third country mid-year — may fail the very test that would have sheltered the payment, in the one year the payment arrives. We routinely see clients lose the exclusion not because the money was the wrong kind but because they moved in the wrong month.

Where is UK severance sourced for US purposes?

Sourcing determines whether the UK tax you paid can actually be credited, and it is the step most often skipped.

Compensation is sourced by reference to where the services were performed. Severance is not compensation for services performed during the severance period — you performed none — so it must be sourced by reference to the services it relates to or replaces. In practice that means a time-basis allocation over a defined period of employment, and the choice of that period is a judgement call that changes the answer materially.

HMRC applies a conceptually similar approach on its side, sourcing a termination payment in the same way as the remuneration it is intended to replace — a PILON, for example, is sourced over the notice period the employee would have worked. The two systems can nonetheless reach different allocations from the same facts, and that divergence is where double taxation actually arises.

Why does this matter so much? Because a senior executive in a London role almost never has a clean 100% foreign workday record. Board meetings in New York, an investor roadshow, three weeks at a US parent's head office — each of those days converts a slice of the severance into US-source income. US-source income supports no foreign tax credit. The UK will still have taxed that slice through PAYE, and unless a treaty re-sourcing position is available and properly claimed, that is real, permanent double tax. Reconstructing a credible workday calendar for the relevant look-back period is unglamorous, and it is frequently worth more than every other line of the return combined. Our cross-border tax planning team treats it as the first deliverable, not an afterthought.

Foreign tax credits: the arithmetic that actually saves the return

Severance falls into the general limitation category on Form 1116. Excess credits carry back one year and forward ten, which gives a badly-timed severance year more flexibility than most people realise — provided the returns exist to carry them into.

The exemption compresses your effective UK rate

Here is the arithmetic that catches executives out. Suppose £30,000 of a £250,000 termination award is exempt in the UK and the balance is taxed at 45%. The UK tax paid is roughly £99,000 — but the US measures that against £250,000 of income, giving an effective rate of around 39.6%. If the US rate on that income exceeds the blended UK rate, there is a residual US liability, and it exists purely because the UK gave you a relief the US does not recognise. The relief did not disappear; it migrated across the Atlantic and became someone else's revenue.

National Insurance is not a creditable tax

Employee National Insurance Contributions are not income taxes and are not creditable for US foreign tax credit purposes; they are dealt with under the US–UK Totalization Agreement, which allocates social security coverage rather than granting credits. This is usually neutral on the termination award itself — the charge on the excess above £30,000 is employer Class 1A, not an employee liability — but it is a live issue on the PENP and PILON elements, which do carry employee Class 1 NIC. Only the income tax component of your PAYE deductions enters the Form 1116 calculation.

The tax year mismatch

The UK tax year runs 6 April to 5 April; the US year is the calendar year. A March termination payment is UK 2025/26 and US 2026. A payment on 10 April is UK 2026/27 and still US 2026. Reconciling a P45 and P60 to a calendar-year US return requires a payment-date reconstruction from payslips and the settlement agreement itself, not a simple transcription of the annual UK figures. Where credits and income land in different years, an accrual election on Form 1116 may align them — but it binds you for all future years, so it is a decision to take deliberately rather than by default.

A worked sequence: the £420,000 exit

Consider a US-citizen executive who left a London-headquartered group in the spring. The agreement provides: £95,000 PENP; £18,000 accrued holiday and unpaid salary; £250,000 ex gratia compensation for loss of office; £40,000 for restrictive covenants; £12,000 as an injury-to-feelings sum tied to an age discrimination allegation; and £5,000 of legal fees paid direct to her solicitors. Her employment covered six years, with an average of eighteen US workdays a year on group business.

The UK outcome is tidy. PENP, salary, holiday and the covenant payment are earnings. Of the £250,000 ex gratia sum, £30,000 is exempt and £220,000 is taxed with employer Class 1A on the excess. The injury-to-feelings sum is contentious but, being termination-related, is treated as taxable. The legal fees are exempt. PAYE settles the lot.

The US outcome requires seven separate determinations: the full £420,000 is gross income; the exclusion is tested for the year of receipt and, if she has relocated, may fail outright; the covenant payment is sourced separately from the wage elements; the injury-to-feelings sum is taxable absent physical injury; the legal fees are includible with deductibility turning on the discrimination pleading; roughly 7% of the wage-type elements are US-source on a workday basis and support no credit; and the creditable UK tax is income tax only, measured against a larger US income base. None of this is visible from the P60.

What if the US returns were never filed?

This is the situation we meet most often. The executive is an accidental American, or a long-term expatriate who let filing lapse a decade ago, or someone who genuinely believed that paying UK tax at 45% discharged every obligation on earth. The severance payment then does two things at once: it creates the largest US liability of their life, and it lands in a UK bank account that has to be reported.

The Streamlined Foreign Offshore Procedures

Where the failure to file was non-wilful, the IRS Streamlined Filing Compliance Procedures remain the principal route back. For taxpayers who meet the non-residency requirement, the foreign offshore track requires three years of delinquent or amended returns, six years of FBARs, and a signed certification of non-wilfulness — with the miscellaneous offshore penalty waived entirely.

The certification is the document that matters, and a severance year makes it harder to draft, not easier. A narrative that explains a decade of non-filing must also explain why the taxpayer engaged professional advisers to negotiate an exit package and did not raise US filing at that moment. It can be explained — UK employment solicitors do not advise on US tax, and there is no reason they would — but it must be explained deliberately and in the taxpayer's own voice. Our IRS streamlined filing specialists draft these certifications for senior clients week in and week out, and the difference between a narrative that survives scrutiny and one that invites it is almost always specificity.

Timing is also strategic. If the severance year falls inside the three-year streamlined window, the liability is settled within the submission. If it falls outside, it is filed as a current-year return alongside the package. Either can be right; choosing without modelling both is not.

FBAR and Form 8938 in the severance year

A six-figure settlement landing in a UK current account pushes almost anyone over the FBAR threshold of $10,000 aggregate maximum balance across all foreign accounts — frequently for the first time, and frequently in accounts the taxpayer had never thought of as "offshore" because they are simply their home bank. Form 8938 thresholds are higher for those living abroad but are measured on both a year-end and a maximum-balance basis, and a lump sum sitting in a savings account for three months can breach the maximum test while the year-end position looks unremarkable.

If you are gauging exposure before you speak to anyone, our FBAR penalty calculator gives an indicative range, and our high-net-worth practice handles the full picture where trusts, carried interest or family investment companies also sit in the background.

Do not forget the state

Federal is not the end of it. A former resident of a high-tax state who spent part of the relevant employment period working there may face a state-source claim on the corresponding slice of severance, and several states apply sourcing rules that are less generous than the federal position. Critically, states do not grant foreign tax credits for UK tax in the way the federal system does, and most do not honour the treaty at all. A modest state exposure can therefore prove harder to relieve than a much larger federal one. Any executive who left a US state within the look-back period should have that state's rules checked explicitly rather than assumed away.

The other components of a senior exit

Severance rarely travels alone. Accelerated or continued vesting of share awards on termination is sourced across the grant-to-vest period on a workday basis, which for a mobile executive produces a genuinely mixed US and UK source result and a reporting position that must be consistent across both returns. Employer pension contributions folded into an exit deal are generally benign in the UK but presumptively taxable to a US citizen unless a treaty position under the pension article is available and correctly claimed — and that claim has to be disclosed, not merely assumed.

Where the package includes deferred payments, an earn-out, or continued benefits, the US cash-basis timing rules and the UK's own receipts basis can diverge by an entire tax year, splitting income and credits apart. Our US–UK tax accountants model the two years together rather than sequentially, because a credit stranded in the wrong year is a credit you may never use.

The filing sequence we follow

• Obtain the executed settlement agreement, all payslips covering the payment dates, the P45, the P60 and any PAYE Settlement Agreement correspondence.
• Decompose the package into US characterisation buckets — wages, non-wage ordinary income, potentially excludible damages, reimbursed fees.
• Reconstruct the workday calendar across the relevant look-back period and compute the US-source and foreign-source split.
• Test Form 2555 eligibility for the year of receipt, including the services-timing cut-off, before assuming any exclusion.
• Convert UK amounts at the correct rate and date, isolating income tax from National Insurance.
• Model Form 1116 with and without an accrual election, and test carryback to the prior year.
• Confirm FBAR and Form 8938 positions for the severance year and the two years either side.
• Where returns are missing, select the compliance route and draft the certification narrative before filing anything.

The mistakes that cost the most

Three recur. The first is treating the £30,000 exempt slice as though it were exempt everywhere — simply omitting it from Form 1040 — which understates income and, more dangerously, understates it in a way that is obvious the moment anyone reconciles the return to the settlement agreement. The second is claiming foreign tax credit against US-source severance, which inflates the credit and invites an adjustment that arrives years later with interest attached. The third is filing the severance year alone, in isolation, without addressing the missing history — a return that is correct in itself but functions as a signed notice that the preceding decade is unfiled.

None of these is difficult to avoid. All of them require someone who reads the settlement agreement as a US tax document as well as a UK one, and who does that reading before the return is prepared rather than after a notice arrives.

If you have exited a UK role under a settlement agreement and your US filings are incomplete — or you simply want the characterisation and sourcing done properly before the return goes in — contact our cross-border team for a confidential, privileged consultation. We will review the agreement, quantify the true US exposure net of credits, and set out the compliance route that resolves the position with the least disruption and the smallest lasting cost.