Severance Payments Are Wages Subject to FICA Tax

On March 25, 2014, the United States Supreme Court issued its ruling in United States v. Quality Stores, Inc., et al., holding in an 8-0 decision that severance payments made to employees involuntarily terminated from employment are generally considered taxable wages under the Federal Insurance Contributions Act (“FICA”). The decision overturns an earlier ruling by the Sixth Circuit Court of Appeals, resolves the conflict on this issue among lower courts and ends prospects for employers across the country to claim refunds of FICA taxes previously paid to the federal government in connection with traditional severance payments.

Background

FICA taxes are imposed on employee wages to fund the Social Security and Medicare programs. Employers and employees pay FICA taxes in equal amounts up to certain limits (the employee’s contributions are made through payroll withholding). Under Section 3121(a) of the Internal Revenue Code, wages are defined for FICA purposes as all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash, subject to specific exceptions.

In the case before the Supreme Court, Quality Stores made severance payments to employees who were involuntarily terminated as part of Quality Stores’ Chapter 11 bankruptcy. The severance payments varied based on job seniority and time served with the employer, and such payments were not linked to the receipt of state unemployment benefits. Quality Stores initially paid and withheld FICA taxes from the severance pay. Subsequently, Quality Stores decided that the severance payments should not have been taxed as wages under FICA and sought a refund on behalf of itself and its former employees. When the Internal Revenue Service did not allow or deny the refund, Quality Stores initiated proceedings in the Bankruptcy Court for a refund of the FICA taxes. The Bankruptcy Court agreed with Quality Stores, and the U.S. District Court and the Sixth Circuit Court of Appeals later affirmed, ruling that the severance payments were not wages under FICA. These decisions were based on Quality Stores’ claim that supplemental unemployment compensation benefits (including severance payments) are not considered wages pursuant to a specific provision of the Code concerning income tax withholding. This interpretation was extended to the definition of wages for purposes of FICA taxes.

Supreme Court Decision

In reaching its decision, the Supreme Court evaluated the history of, and the correlation between, the definition of wages for FICA tax purposes and the definition of wages for income tax purposes. First, the Supreme Court noted that the definition of wages for FICA tax purposes contains specific exceptions, some of which would not be necessary if severance payments in general were not within FICA’s definition of wages. Second, the Supreme Court noted that in 1950 Congress repealed an exception from the definition of wages for “dismissal pay,” which indicated to the Court that Congress intended for severance pay to be subject to FICA taxes. Finally, the Supreme Court disagreed with Quality Stores’ broad interpretation of the treatment of supplemental unemployment compensation benefits, concluding that only severance payments tied to the receipt of state unemployment benefits are exempt from income tax withholding and FICA taxation (as provided under existing guidance from the Internal Revenue Service).

Practical Takeaways

The Supreme Court’s decision in favor of the federal government settles a controversy concerning the proper FICA tax treatment of severance pay that had been ongoing for several years. Based on this decision, employers should continue to treat traditional severance pay as wages subject to FICA tax. Likewise, employers that had filed, or were planning to file, claims for a refund of FICA taxes on traditional severance pay can abandon such actions or plans. Given the outcome of the case, it is anticipated that the Internal Revenue Service will deny any pending or future refund claims where the severance payments were made to employees who are involuntarily terminated from employment, the payments were varied based on job seniority and time served, and the payments were not linked to the receipt of state unemployment benefits.

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