On Tuesday, March 25th, the Supreme Court ruled that severance payments not linked to State unemployment benefits paid to involuntarily terminated workers were "wages" and thus subject to Social Security and Medicare taxes under the Federal Insurance Contributions Act (FICA.) This ruling reverses the Sixth Circuit's 2012 decision where the opposite conclusion was reached. Both the Sixth Circuit and Supreme Court cases arose out of the bankruptcy of Quality Stores, Inc., a now defunct retailer of agricultural products.
In Tuesday’s unanimous opinion the Court rejected Quality Stores' contention that severance payments to employees who were laid off as part of the company's bankruptcy process were not taxable wages subject to FICA. In particular, Quality Stores argued that the FICA definition of wages should be interpreted in light of the income-tax withholding rules. The withholding rules define "wages" in substantially the same manner as the FICA rules. Thus, Quality Stores argued that the "as if" language in Internal Revenue Code Section 3402(o) of the withholding rules, which instructs that "any supplemental unemployment compensation benefit paid to an individual . . . shall be treated as if it were a payment of wages," should be interpreted as excluding severance payments that qualify as supplemental unemployment compensation benefits from the definition of wages under FICA. The Supreme Court flatly rejected this argument, explaining that Section 3402(o) of the withholding rules does not cause severance payments to fall outside of the extremely broad definition of wages under FICA. Because the Supreme Court rarely addresses what constitutes wages for FICA purposes, this all-encompassing interpretation of the term “wages” will surely have broad implications in many settings for years to come.
Given this Supreme Court decision, the IRS will not have to provide refunds of overpaid FICA on severance payments to those employers who may have requested refunds based on the taxpayer favorable Sixth Circuit case. There were over $1 billion of pending refunds claims on this issue. Going forward, employers must unfortunately treat employee severance payments that are not tied to the receipt of State unemployment insurance as taxable employee wages for purposes of calculating their FICA tax liabilities.