It’s a common scenario for many employers. An employee who is terminated by the employer is offered a severance package.  The employee would prefer that the severance payments are made under a 1099 (and therefore not subject to any tax withholdings).  Doing so would also be easier, from an administrative perspective, for the employer.  Is this legal?  In other words, are such payments considered taxable wages from which certain taxes must be withheld and paid by the employer?

The United States Supreme Court clarified the issue recently in United States v. Quality Stores, Inc., where it unanimously held that lump sum severance payments made to involuntarily terminated employees can be taxable wages under the Federal Insurance Contributions Act (“FICA”).  The decision complicates matters for employers and employees alike.  It confirms that severance pay is subject to FICA tax if it is not tied to the receipt of state unemployment benefits and means that employees take home less money from severance payments than expected.

The case arose when Quality Stores, formerly one of the county’s largest agricultural retailers, laid off more than 3,000 workers after filing for Chapter 11 bankruptcy.  Quality Stores paid its departing employees lump sum severance payments that varied with seniority and position, but which were not tied to the receipt of state unemployment benefits.  Although the company reported the payments as wages on W-2 tax forms and withheld/paid FICA taxes, it later disputed these taxes and sought a refund from the IRS.

Overturning lower court rulings, the Supreme Court found that these severance payments were taxable wages under FICA.  FICA defines wages broadly to include all remuneration paid for employment.  Employment is any service performed by an employee for an employer and includes not only the work actually done but the entire employment relationship.  The court reasoned that Quality Stores’ severance payments, which varied according to position and seniority, were wages under that definition.

The ruling, however, leaves some gray area for employers to navigate because it does not impact the taxability of severance payments that are linked to state unemployment benefits.  In fact, the Court expressly noted that, under the current IRS rules, severance tied to state unemployment compensation is exempt not only from income-tax withholding but also from FICA taxation.