SCOTUS: Severance payments are taxable

published in McAfee & Taft EmployerLINC Alert | March 26, 2014

By Paul A. Ross

In the words of noted American statesman Benjamin Franklin, “in this world nothing can be said to be certain, except death and taxes.” Given Franklin’s thoughts, yesterday’s decision by the U.S. Supreme Court in the case of United States v. Quality Stores, Inc., probably would have come as no surprise. In that case, the court ruled that most severance payments made to terminated employees are in fact “wages” subject to FICA tax by both the employee and the employer.

Like many employers over the last several years, Quality Stores, Inc. recently encountered difficult financial times, unfortunately leading to bankruptcy. As a result, the company terminated the employment of thousands of employees. However, the company made severance payments to the affected employees that varied by job title and years of service with the company — a practice that is fairly traditional with severance plans. From those severance payments, the company calculated and paid both the employer and employee portions of payroll taxes that would typically be due on wages under the Federal Insurance Contributions Act, commonly known as “FICA.” Later, Quality Stores re-examined the definition of “wages” under FICA and concluded that the severance payments should not have been treated as taxable. The company sought a refund of the related FICA contributions on behalf of itself and on behalf of about 1,850 former employees. Not surprisingly, the IRS issued no such refund, and Quality Stores, Inc. filed suit.

W2Quality Stores argued that FICA’s broad definition of taxable “wages” did not include severance payments. The bankruptcy court, the district court, and the U.S. Sixth Circuit Court of Appeals all agreed. Recognizing that other courts of appeals had previously held differently, the U.S. Supreme Court took the case to resolve the split in authority. In a unanimous opinion, the nation’s highest court overturned the rulings of all three lower courts, concluding that these types of severance payments are taxable wages for the purposes of FICA.

The Supreme Court based its decision on the technical wording of the FICA statute and a similar provision in the Internal Revenue Code relating to income tax withholding. According to the court, both the statutory definitions of wages and the regulatory background of these provisions could support only one conclusion – that the payments were in fact taxable. The court left open the question of how the result might be different for severance payments that qualify as “supplemental unemployment benefits” or “SUB” plans. But given that Quality Stores’ severance plans were not in any way tied to unemployment compensation, the court did not go so far as to question the IRS’s treatment of SUB plans. Of course, SUB plans are not common, and most severance payments made by most employers fall squarely within the ruling issued by the court in this case.

The Quality Stores opinion serves as a great reminder that employers deal in “wages.” In most cases, severance (and settlement) payments may qualify as “wages” that will be subject to payroll taxes, income taxes and/or withholding obligations. Employers should undoubtedly keep these principles in mind when evaluating severance and settlement opportunities in the future. It looks like Ben Franklin was right.