Gregory S. DuPont
Supreme Court Rules That Severance Pay Is Subject to FICA Taxes
The Supreme Court essentially upheld the IRS’s long-standing position that severance payments to workers are subject to the Social Security and Medicare payroll taxes mandated by the Federal Insurance Contributions Act, or FICA. Under FICA, employers and employees are required to each pay 6.2% in Social Security taxes on wages up to a cap ($117,000 in 2014), and to each pay 1.45% of all wages toward Medicare.
In the wake of the judgment, most legal experts agreed that the employers that filed protective refund claims following the Sixth Circuit’s 2012 decision in the Quality Stores case would not be entitled to a refund of FICA taxes paid for severance compensation. According to a brief in the case filed by the Obama administration, claims for refunds totaling more than $1 billion had been made in 11 unresolved lawsuits and 2,400 administrative cases.
The respondent in the case was Quality Stores, Inc., an agricultural specialty retailer based in Muskegon, Michigan. The company entered Chapter 11 bankruptcy proceedings in 2001 and terminated around 3,100 employees before and following the filing. The employees received severance payments, which all parties agreed were the result of a reduction in the workforce or the discontinuance of a plant or operation. Quality Stores reported the severance payments as wages on W-2 tax forms, paid the employer’s required share of FICA taxes, and withheld employees’ share of FICA taxes. The company did not question the assumption that the severance payments constituted income under the income tax, or that the employer was required to withhold a portion of the payments for income tax purposes.
However, the company later disputed whether the payments constituted “wages” for purposes of the payroll tax imposed by FICA on the grounds that the payments instead constituted supplemental unemployment benefits (SUBs) under Internal Revenue Code (IRC) Section 3402(o)(2). Quality Stores then asked the terminated employees to allow the company to file FICA tax refund claims on their behalf. Quality Stores initiated a proceeding in bankruptcy court seeking a refund of just over $1 million in FICA taxes on its own behalf and on behalf of the 1,850 former employees who agreed to participate.
The bankruptcy court granted summary judgment in the company’s favor, even though several circuit courts had previously held that at least some severance payments were “wages” subject to FICA taxes. The District Court and Court of Appeals for the Sixth Circuit subsequently affirmed the bankruptcy court’s decision that the severance payments made by Quality Stores were properly classified as SUB payments, not as wages for purposes of FICA tax withholding, and that Quality Stores and their former employees were therefore entitled to a refund.
In overturning the Sixth Circuit’s ruling, the Supreme Court largely followed the broad definition of wages and employment for FICA purposes under IRC Sections 3121(a) and (b) and prior Supreme Court precedents, while rejecting Quality Stores’ contention that certain involuntary layoff payments could be exempt from FICA if those payments qualified as SUB payments.
Writing for the Court, Justice Anthony Kennedy said the first question in the case is whether FICA’s definition of “wages” encompasses severance payments. Referring to prior decisions and to the wording of FICA itself, the Court pointed out that FICA defines “wages” as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash;” and that the term “employment” encompasses “any service, of whatever nature, performed . . . by an employee for the person employing him.”
It was also significant to the Supreme Court’s analysis that the extensive and specific list of exemptions from the definition of “wages” did not include severance payments. “The severance payments here were made to employees terminated against their will, were varied based on job seniority and time served and were not linked to the receipt of state unemployment benefits,” Justice Kennedy wrote. “Under FICA’s broad definition, these severance payments constitute taxable wages.”
The Supreme Court further stated in its opinion that the IRS rulings exempting the specially structured arrangements for severance payments explicitly tied to the receipt of state unemployment benefits from income tax withholding and FICA taxation are still in effect, as they were not at issue in the case. However, it appears that following this decision most severance payments will subject to FICA taxes, as well as to income tax withholding.
“Today, the Supreme Court made clear that severance payments for employees terminated against their will generally are subject to taxation under the Federal Insurance Contributions Act,” said Robert S. Hertzberg, the lawyer who represented Quality Stores at the Supreme Court.
“The decision is a huge blow for employers and employees alike,” Hertzberg added. “In addition to the impact on Quality Stores and its former employees, this ruling has far-reaching implications for the thousands of other organizations and workers fighting for refunds.”