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Are severance payments subject to FICA taxes? The Supreme Court sides with the IRS.

In the current economic climate, bankruptcies and loss of employment are an unfortunate reality. When affected employees receive severance payments, these proceeds constitute taxable income. The issue of withholding Federal Insurance Contributions Act (FICA) taxes from these payments has been the source of much litigation. On March 25, 2014, the U.S. Supreme Court unanimously decided that severance payments made to employees who are involuntarily terminated are subject to Social Security and Medicare taxes [U.S. v. Quality Stores, S.Ct. 12-1408 (March 25, 2014)]. The decision saved the IRS from refunding more than tens of millions of dollars to employers and employees, and it resolved a split in the federal circuits. As a result of this decision, employers should treat severance payments to involuntarily terminated employees as taxable wages subject to FICA taxes.


Quality Stores used to be the largest agricultural retailer in the United States. Pursuant to a 2001 Chapter 11 bankruptcy reorganization, Quality Stores was forced to close all of its 374 stores and distribution centers and lay off all of its employees. The company made severance payments to the employees whose employment was involuntarily terminated. The federal government and Quality Stores agreed that the severance payments resulted from either a reduction in force or the discontinuance of a plant or operation.

The company offered its employees a series of severance packages both before and after filing its bankruptcy petition. The amount of the payments depended upon the employees' position and their years of service. The payments were not tied to receipt of state unemployment compensation. The severance pay ranged from one week to 18 months.

Quality Stores reported the payments as wages and withheld income tax accordingly; it paid the employer's share of FICA tax and withheld the employee's share. Quality Stores did not agree with the IRS's position that the severance payments constituted wages for FICA purposes, so it filed claims for refunds of both the employer portion and, to the extent they received authorizations from the employees, the employee portion of the tax. In their claims, Quality Stores took the position that the severance payments were not wages but constituted supplemental unemployment compensation benefits (SUB), which are not taxable under FICA. When the IRS neither granted nor denied the refund, Quality Stores filed an adversary action in the bankruptcy court, which agreed with Quality Stores that the severance payments were nontaxable SUB payments under FICA and ordered the IRS to refund the overpaid taxes.

Shortly after the bankruptcy court decision, the Federal Circuit Court held in CSX Corp v. U.S. [518 F.3d 1328 (Fed. Cir. 2008)] that the severance payments were subject to FICA withholding. The Federal Circuit concluded that IRC section 3402 should not necessarily apply to FICA withholdings. After the CSX decision was issued, the government filed a motion for reconsideration of Quality Stores with the bankruptcy court on the basis of that decision. Upon reconsideration, the bankruptcy court ratified its decision [Quality Stores, Inc. v. United States (in re Quality Stores), 383 B.R. 67 (Bankr. W.D. Mich. 2008)].

The government subsequently appealed to the federal district court for the Western District of Michigan, which affirmed the bankruptcy court's decision [United States v. Quality Stores, 693 F.3d 605 (6th Cir. 2012)]. The court held that the "treated as if it were a payment of wages" language in IRC section 3402(o) clearly meant that the SUB payments were not wages. The court also held that since SUB payments are defined as nonwage payments for income tax withholding, they are also nonwage payments for FICA withholdings [Rowan Cos., Inc., v. United States, 452 U.S. 247 (1981)]. The Sixth Circuit held that payments made by Quality Stores to its employees, which the parties had stipulated met the statutory definition of "supplemental unemployment compensation benefits," did not constitute "wages" subject to FICA taxation. The government petitioned the Supreme Court to hear the case with a writ of certiorari.

Analysis of the Supreme Court

The unanimous decision by the Supreme Court rejected Quality Stores' contention that the supplemental unemployment compensation was exempt from FICA, thereby reversing the Sixth Circuit. The opinion, written by Justice Kennedy, held that the payments constituted severance payments under FICA's broad definition.

The Supreme Court first examined whether the term "wages" for FICA purposes encompasses severance payments. FICA defines "wages" as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash" [IRC section 3121(a)], Because severance is only provided by to employees by its very nature, the court determined that it must be considered "remuneration for employment." The decision stated:

   Under this definition, and as a matter
   of plain meaning, severance payments
   made to terminated employees are remuneration
   for employment. Severance
   payments are, of course, remuneration,
   and common sense dictates that employees
   receive the payments for employment.
   Severance payments are made to
   employees only. It would be contrary
   to common usage to describe as a severance
   payment provided to someone
   who has not worked for the employer.

This conclusion was supported by FICA's list of exemptions from the definition of "wages," including a specific exemption for any severance payments made "because of ... retirement for disability" [IRC section 3121(a)(13)(A)]. It was significant to the Court because the list does not include severance payments. The decision found further support for its conclusion that the term "wages" includes severance payments in FICA's legislative history.

In addition, not long after the Social Security Act was originally enacted, the Treasury Department promulgated a regulation stating that, for purposes of the payroll tax, "dismissal pay" constituted "wages." In 1939, Congress overruled that regulation by statute, providing that wages did not include "dismissal payments which the employer is not legally required to make." In 1950, however, Congress repealed that provision, plainly indicating its view that the term "wages" includes severance payments.

Next, the Court examined IRC section 3402(o), related to income tax withholding as a limitation on the meaning of the wages for FICA purposes. IRC section 3402(a) provides that "any supplemental unemployment compensation benefit paid to an individual shall be treated as if it were a payment of wages by an employer to an employee." The Court found that the definitional section for income tax withholding, like the definitional section for FICA, contains a series of specific exemptions that support a broad scope of its definition of wages. The Court rejected the Sixth Circuit's ruling that the "as if' language meant severance payments were not covered by FICA's "wage" definition.

Resolving the Split

The Supreme Court's decision in Quality Stores, though disappointing to many employers and employees who looked to recover refunds, resolved the conflict between the Sixth Circuit and Federal Circuit. It effectively resolves the issue of whether or not severance pay outside of the traditional SUB plan would be excluded from income. The types of severance payments in this case would be taxable for FICA, and no refund claims will be processed. The decision by the Supreme Court is consistent with the IRS's long-held position on the tax treatment of severance payments. It is important to note that severance payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding, but also from FICA taxation. Because the payments in Quality Stores were not linked to state unemployment benefits, the Court did not address the question of whether the IRS's current exemption is consistent with the broad definition of wages under FICA.

Maria M. Pirrone, JD, LLM, CPA, is an assistant professor of taxation at St. John's University, Jamaica, N.Y.
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Title Annotation:Taxation: federal taxation
Author:Pirrone, Maria M.
Publication:The CPA Journal
Date:May 1, 2015
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