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United States Supreme Court Rules that Severance Payments are Subject to FICA Tax

April 24, 2014

On March 25, 2014, the United States Supreme Court issued a unanimous ruling in United States v. Quality Stores, Inc., holding that the severance payments at issue in the case were subject to FICA taxes.  After the lower court ruling in the case in 2012, there was considerable commentary suggesting that employers could forego subjecting severance payments to FICA tax, and could even apply for a refund of FICA tax already paid on severance payments.  The Supreme Court’s ruling now settles what had been a somewhat unclear area of the law: severance payments that are subject to income tax withholding are also subject to FICA tax.

Quality Stores, Inc. (“Quality Stores”) was an agricultural retail store that entered into bankruptcy proceedings in 2001.  Prior to filing for bankruptcy, Quality Stores involuntarily terminated thousands of employees and subsequently provided such employees with severance payments as a result of a reduction in force and/or the discontinuance of a plant or operation.  Quality Stores reported the severance payments as wages on Form W-2, paid the employer’s share of FICA taxes and withheld each employee’s share of FICA taxes.  Quality Stores subsequently filed FICA tax refund claims totaling approximately one million dollars on behalf of itself and 1,850 former employees.  The case made its way up to the Sixth Circuit, which is the federal court of appeals for Michigan, Ohio, Kentucky and Tennessee.

In 2012, the United States Court of Appeals for the Sixth Circuit sided with Quality Stores and held that the severance payments at issue were not wages and therefore FICA taxes should not have been withheld from them.  As a rule, FICA taxes must be withheld on all “wages” paid by employers to employees.  The Sixth Circuit relied on Internal Revenue Code (“Code”) Section 3402(o), Extension of Withholding to Certain Payments Other Than Wages, in holding that the severance payments at issue were not wages for FICA purposes.  The Code’s income tax withholding provisions provide, in part, that “any supplemental unemployment compensation benefit paid to an individual…shall be treated as if it were payment of wages by an employer to an employee for a payroll period.”  The Code defines “supplemental unemployment compensation benefits” as amounts which are paid to an employee because of an employee's involuntary separation from employment, resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions.

The Sixth Circuit opined that because the Code provides that supplemental unemployment compensation benefits shall be treated as if they were a payment of wages for purposes of the Code’s income tax withholding provisions, then it rationally follows that such severance payments are not actually wages and therefore FICA taxes cannot be withheld from them.  The Supreme Court disagreed.  Writing for the Supreme Court, Justice Kennedy based the ruling on two factors.  The first was the plain reading of the definition of wages for purposes of FICA.  Code Section 3121(a) defines FICA wages as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.”  The Supreme Court found that severance payments made to terminated employees are remuneration for employment because they are payments made in connection with the employee’s services for the employer.

The Supreme Court’s second line of reasoning directly refutes the Sixth Circuit’s holding that the Code’s treatment of severance payments as if they were wages is an indirect way of stating that the definition of wages does not include severance payments.  The Supreme Court noted that States have a history of providing unemployment benefits only to terminated employees not earning wages.  To address this issue, the IRS took the position that severance payments tied to the receipt of state unemployment benefits were not wages so that employees could receive both severance payments and state unemployment benefits.  To tackle the specific problem that severance payments were still taxable income and not withholding from them could lead to large tax liabilities for terminated employees, Congress enacted Code Section 3402(o), which treats employer-provided severance payments “as if” they were wages requiring tax withholding.

Nonetheless, the Supreme Court noted that IRS Revenue Ruling 90-72 provides both a withholding exemption and a FICA exemption for severance payments that are tied to the receipt of state unemployment benefits.  Because the severance payments at issue in the Quality Stores case were not tied to the receipt of state unemployment benefits, the Supreme Court did not address this issue in its ruling.

The takeaway from this case is that employers should pay their share of FICA tax, and withhold their employees’ share of FICA tax from severance payments, other than severance payments that are directly tied to the receipt of state unemployment benefits.  As always, please contact any of the lawyers in the Employee Benefits Practice Group for further guidance. 

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