Supreme Court Rules Companies must Pay Taxes on Severance Payments

Recently, we explored the uncertainty surrounding the gray area of severance pay and taxation. Part of the fallout from the recession has been layoffs, and the resulting severance paid to those employees who were let go. At question was whether or not severance payments were considered wages for the purpose of the Federal Insurance Contributions Act tax (FICA). FICA is paid by both the employer and employee, and consists of a 6.2% payroll tax for Social Security and 1.45% tax for Medicare.

Much needed clarification arrived with the U.S. Supreme Court's Tuesday, March 25, 2014 ruling on US vs. Quality Stores Inc, that severance pay is indeed taxable under FICA. In doing so the Supreme Court overturned a 2012 ruling from the 6^th U.S. Circuit Court of Appeals, which ruled that severance payments to former employees were not wages, thus not taxable under FICA. The ruling saves what could have resulted in more than $1 billion in refund claims to the Internal Revenue Service, as well as the loss of a significant future revenue stream.

Specifically the Court ruled that "severance payments are not exempted, and they squarely fall within the broad textual definition of wages for purposes of income-tax withholding". As such, severance payments employers made to involuntarily laid-off employees are "wages" and are taxable under FICA. The Court based its decision on two things. First, they analyzed (1) the definition of "wages" in FICA - a statute that taxes "wages" paid by an employer or received by an employee "with respect to employment," to fund Social Security and Medicare benefits. Second, the Court looked at the Internal Revenue Code (IRC) § 3402(o) - which governs income-tax withholding (2).

1. As to the FICA definition - that "wages" means "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash," FICA § 3121(b) - the Court held that severance payments are, "of course, 'remuneration,'" and that "common sense dictates that employees receive the payments 'for employment.'"
2. As to IRC § 3402(o) - which provides that "any supplemental unemployment compensation benefit paid to an individual shall be t???reated as if it were a payment of wages by an employer to an employee" - the Court rejected the Sixth Circuit's ruling that the "as if" language meant severance payments were not covered by FICA's "wages" definition.

So is there any good news for employers coming out of this decision?

Employers will no longer face different tax requirements depending on where their former employees worked. The Court's ruling resolves the inconsistency between lower courts that the Sixth Circuit's Quality Stores decision created. It was in direct odds with a Federal Circuit's 2008 decision that severance payments are taxable under FICA (in a case titled CSX Corp. v. U.S.). Also, the Supreme Court's Quality Stores decision is consistent with the IRS' long-held position on the taxability of severance payments, as well as with most employers' current and long-term practices in compliance with that IRS position.