U.S. Government To Supreme Court : Severance Pay Subject To FICA Taxes

Alizah Z. Diamond for Schnader Harrison Segal & Lewis writes: On Tuesday (January 14, 2014), the Internal Revenue Service argued before the U.S. Supreme Court in U.S. v. Quality Stores Inc. et al., case no. 12-1408, that severance payments made to employees following involuntary termination of employment should be subject to payroll taxes under the Federal Insurance Contributions Act (FICA). Severance pay already is taxed as ordinary income for income tax purposes. FICA taxes are paid by both an employer and its employees and are intended to help fund Social Security retirement and Medicare.

The issue is whether severance payments should be considered "wages" under the Internal Revenue Code. Following its bankruptcy in 2001, Quality Stores withheld millions of dollars in FICA taxes from its severance payments to thousands of terminated employees. Quality Stores argued that severance payments fall under the definition of "supplemental unemployment benefits," which are not considered wages for income tax withholding purposes under §3402(o) of the Internal Revenue Code of 1986 and, therefore, the company and its former employees are entitled to refunds. The IRS argued that the severance payments are within FICA's definition of taxable wages because they constitute "remuneration for employment."

The Sixth Circuit Court of Appeals previously found for Quality Stores. In another refund case, CSX Corp. v. U.S., case no. 2007-5003, the Court of Appeals for the Federal Circuit found for the government. The IRS argued before the Supreme Court that the Sixth Circuit erred in relying on the income tax withholding statute because that statute is limited to income tax withholding and has no bearing on the definition of wages under FICA. Quality Stores argued that because receipt of severance pay "is contingent...upon losing your job," such payments are not remuneration for services under FICA.

The Court is expected to decide by the end of June. The outcome of the case should have far-reaching consequences. If it loses, the government may be required to issue more than $1 billion in refunds to former employees of Quality Stores. A decision in favor of the government could alter the structure of severance arrangements as it would impose greater financial burdens on employers and reduce the amount of pay actually received by employees.