Supreme Court holds that severance benefits are subject to FICA taxes

April 15, 2014
Legal update

As tax day is upon us, the U.S. Supreme Court reminds us of the many ways the IRS can reach into our pockets. The Supreme Court held that severance payments made to involuntarily terminated employees are taxable wages under the Federal Insurance Contribution Act (FICA). U.S. v. Quality Stores, Inc., 572 U.S. ____(2014).

This opinion reverses the Sixth Circuit’s 2012 determination that an employer is entitled to a refund of FICA taxes which had been withheld from severance payments made to employees who were involuntarily terminated in a reduction in force (RIF). The Sixth Circuit’s decision created a split among the federal appellate courts, which the Supreme Court has now resolved in favor of the IRS.

What are the facts of the Quality Stores case?

When Quality Stores underwent several RIFs, where jobs were eliminated and stores were closed, employees whose jobs were eliminated as a part of a RIF received severance packages under plans developed by Quality Stores. Under these plans, employees were paid a certain number of weeks of severance. The amount of severance each employee received varied depending on the employee's position and years of service with the company. Some employees were paid over a period of time in accordance with the company's payroll schedule, while others received a lump sum payment. Following the only available guidance from the IRS, Quality Stores withheld FICA taxes from the employees' severance checks and also paid its share of the FICA taxes on those payments. Subsequently, however, Quality Stores made a request for refund of the FICA payments from the IRS arguing that the payments were not "wages" for purposes of that tax. The IRS disagreed, and the matter was initially resolved by a bankruptcy court in Quality Stores' favor. The Sixth Circuit then analyzed all of the competing – and often conflicting – statutory and regulatory provisions and concluded that the FICA tax was not required to be withheld from the severance payments in issue, and that Quality Stores was, therefore, entitled to a refund. On appeal, the U.S. Supreme Court reversed the Sixth Circuit holding that severance payments are included in FICA’s broad definition of wages as “all remuneration for employment,” and are, therefore, taxable wages.

Why did the Supreme Court Rule this Way?

The Supreme Court based its decision on the broad definition of “wages” under FICA, which provides that wages are “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” Because Quality Stores based the severance payments on factors such as the employees’ job duties the Court concluded that these payments constituted “remuneration for employment,” just like “health and retirement benefits, stock options, or merit-based bonuses.”

The Supreme Court found that the Sixth Circuit erred in its reliance upon a regulatory provision which provides rules for supplemental unemployment compensation benefits, such as severance payments to mean that severance payments are not actually “wages” under FICA. Upon a lengthy review of the regulatory history of that provision, the Supreme Court concluded that the Sixth Circuit’s interpretation was incorrect, and that the provision does not narrow the term “wages” under FICA to exempt all severance payments. Accordingly, the Court held that “[u]nder FICA’s broad definition, these severance payments constitute taxable wages.”

What are the implications for employers and individuals?

This decision clears the air regarding whether involuntary severance payments are subject to FICA taxes. Going forward, employers should be certain to treat severance payments for involuntary terminated employees as taxable wages. Those employers that requested protective refund claims will have those claims denied, and the IRS will keep the refund money it has held pending the outcome of this case. Any employer or employee that did not pay FICA taxes on involuntary severance payments will owe FICA taxes on those payments.

For more information, please contact Anne McNab or Martin Mooney, or any member of Frost Brown Todd’s Labor and Employment or Tax Law practice groups.