Court Rules Supplemental Unemployment Compensation Not Subject to Social Security, Medicare Taxes

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In a case from West Michigan, the federal court of appeals in Cincinnati recently ruled that certain payments of supplemental unemployment compensation are not “wages” subject to Social Security or Medicare taxes under the Federal Insurance Contributions Act (FICA). This ruling is significant to employers who have made similar payments and may be eligible for a refund.

Background

The employer made periodic and lump-sum severance payments to employees after the employer went out of business and filed bankruptcy. None of the payments were conditioned on receipt of state unemployment compensation. The employer reported the payments as wages on W-2 forms and withheld income and FICA taxes from them.

At the time, the IRS was applying FICA taxes to all severance payments except payments made in installments (not lump sums) to employees receiving unemployment compensation under state law.

The employer challenged the IRS's position by filing refund claims to recover more than $1 million in FICA taxes. The employer argued that FICA does not apply to any severance payment that satisfies the statutory definition of “supplemental unemployment compensation” in section 3402(o) of the Internal Revenue Code. The bankruptcy court agreed with the employer, and both the federal district court and the federal court of appeals agreed with the bankruptcy court.

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