Supreme Court rules that severance pay is FICA-taxable

April 8, 2014

In a unanimous decision, the U.S. Supreme Court on March 25 reversed the 6th Circuit Court of Appeals, ruling that an employer’s severance pay plans were FICA-taxable. As a result, the IRS isn’t on the hook to pay up to $1 billion in FICA refunds to various employers and their employees who were let go over the past several years. (U.S. v. Quality Stores, Inc., No. 12-1408, U.S. S.Ct., 2014)

What it means for employers: This decision makes clear that employers should withhold FICA taxes from most severance payments.

The million-dollar question. The severance pay plans at issue were fairly ordinary. Quality Stores filed for bankruptcy in 2001, and paid severance pay to its employees.

Severance was based on employees’ years of service, job grade and whether they were managers or rank-and-file employees. Some severance was paid periodically on employees’ normal paydays; other employees received lump sums. No employee was required to apply for unemployment benefits.

The company withheld FICA from the payments and later applied for a refund totaling over $1 million. The government and the company then stipulated that the payments qualified as supplemental unemployment benefit pay, or SUB pay.

SUB pay isn’t wages subject to income tax withholding, but it is taxable. Tax code Section 3402(o) requires employers to withhold income taxes from SUB pay, as if it were wages. In order for SUB pay to be excluded from FICA, however, it must be tied to the receipt of unemployment benefits and employees can’t receive it in lump sums.

Eventually, the case reached the 6th Circuit Court of Appeals, which ruled that since SUB pay was only treated as if it were wages, it wasn’t taxable for FICA.

The billion-dollar answer. The court first ruled that severance pay in general is FICA-taxable. Court: FICA defines wages broadly as all remuneration for employment. As a matter of plain meaning, the court continued, severance payments fit this definition—they are a form of remuneration paid only to employees in consideration for employment.

The court next addressed the interplay between Section 3402(o) and FICA. Court: Similar to FICA, the definition of wages for income tax withholding purposes is broad, and severance pay isn’t among the exemptions from withholding. It then noted that Section §3402(o) didn’t narrow the term “wages” under FICA to exempt all severance payments. Key: The court said that in order for tax administration to be as simple and consistent as possible, the definition of wages for income tax withholding purposes and FICA purposes should be the same.

WHAT’S LEFT ON THE TABLE: The court didn’t decide whether the IRS’ criteria for FICA-free SUB pay, as delineated in IRS Pub. 15-A, were valid. Result: Severance payments that meet the current definition of SUB pay will be FICA-free to employers and employees.