Can Severance Pay Be Taxed? / With Billions of Dollars at Stake, the Supreme Court Has Agreed to Address the Issue

Laura Saunders for the Wall St Journal writes: A year ago, we reported a disagreement between two federal appeals courts as to whether payroll taxes are due on severance payments made to laid-off workers. We predicted the issue could wind up before the U.S. Supreme Court.

Now it has. In October, the court said it would hear one of the cases, U.S. v. Quality Stores, which the Sixth Circuit decided in favor of taxpayers. Oral arguments are scheduled to begin Jan. 14.

A great deal of money is at stake. More than 2,400 claims have been filed requesting total refunds of more than $1 billion in Social Security and Medicare taxes, according to Internal Revenue Service data cited in the government's petition to the court.

One claim filed by a firm can cover hundreds or even thousands of former employees, and some are more than a decade old, says Marianna Dyson, an employee-benefits lawyer at Miller & Chevalier in Washington.

Ordinarily, employees and employers each owe a flat Social Security tax of 6.2% up to a cap ($113,700 in 2013), plus an unlimited Medicare tax of 1.45% on wages, for a total rate as high as 15.3%. Together these are known as FICA, or payroll, taxes. (In 2011 and 2012, there was a temporary two-percentage-point cut in the worker's portion of Social Security tax, and starting this year affluent workers owe an extra 0.9 percentage point of Medicare tax.)

Tax refunds for individuals also could be substantial. For an executive laid off early in 2009 who received $100,000 of severance, the total refund could come to about $15,000 plus interest, split equally between the worker and the firm, says Ruth Wimer, a partner at law firm McDermott Will & Emery in Washington.

How will the court rule? Experts say the outcome of tax cases often is hard to predict, in part because the justices accept very few of them.

"Severance is paid in lieu of further wages, so the government has a good argument in favor of the tax," says Michael Graetz, a tax-law scholar who teaches at Columbia University's law school. "On the other hand, the government has lost its last three tax cases in the Supreme Court."

The justices also could take into account the huge potential revenue loss, say other experts. Ms. Dyson notes that a tie vote is possible, as Justice Elena Kagan has recused herself from the case. If there is a tie, the decision would be affirmed for the Sixth Circuit (Tennessee, Kentucky, Ohio and Michigan) and the court might take up the issue again in another case, Ms. Dyson says.

Here's what experts say employers and employees affected by this issue need to know.

Employers should continue to withhold payroll taxes on affected pay until the decision comes down, even if the company is located within the Sixth Circuit.

Employers should file refund claims for the taxes. The filing needs to be made with the IRS within three years of the April due date following the calendar year of the severance payment.

So if a firm paid severance in 2010, it has until April 15, 2014, to file a refund claim. This will be after the court hears arguments on the issue but before there is likely to be a decision, Ms. Wimer notes.

In the past, firms that had refund claims denied by the IRS needed to file a suit in U.S. District Court or the U.S. Court of Federal Claims within two years to preserve the right to benefit from a favorable Supreme Court decision.

This summer, however, the IRS issued a statement saying that if the two-year deadline is approaching, it will sign an agreement to extend the deadline pending the court's decision on this issue. This could save firms the expense of filing a court challenge.

Laid-off workers should ask former employers if the firm is pursuing a payroll-tax refund. Some firms have alerted former workers that they are doing so, but they aren't required to notify them unless the IRS agrees to pay a claim.

At that point, the employer asks former workers for consent to include their claims with its own. This sets up a process so that the company can pay former workers their shares of refunded tax.

If the employer didn't file a refund claim but the former worker believes he is entitled to one, then often he can file IRS Form 843 to make a claim, says an IRS spokesman.

But the worker must make the claim within the statute of limitations, often three years after he files the return reporting the severance pay.

If taxpayers win the case and receive payroll-tax refunds, the money isn't taxable—but the interest is, Ms. Wimer says.