Severance Payments Remain Taxable Wages for Purposes of FICA

by Cozen O'Connor

In an eight to zero decision (with Justice Kagan recused), the U.S. Supreme Court held on March 25 in United States v. Quality Stores, Inc. that severance payments made to involuntarily terminated employees are “wages” under the Federal Insurance Contributions Act (FICA) and must be taxed accordingly.

Respondent, Quality Stores, entered into bankruptcy in 2001 after experiencing financial difficulties. During the pendency of the bankruptcy proceedings, Quality Stores was forced to terminate 3,100 of its employees. The employees received severance payments, in varying amounts, according to their seniority and position with the company. Quality Stores reported the severance payments on W-2 tax forms and withheld the proper amount of FICA taxes. Thereafter, Quality Stores initiated legal proceedings to recoup tax refunds on its own behalf and on behalf of its former employees in the amount of $1,000,125.00.

The key issue before the U.S. Supreme Court was whether severance payments paid to the terminated employees constituted wages for purposes of FICA. The 6th Circuit, affirming the decisions of the bankruptcy and district courts, held that severance payments were not “wages” under FICA. The United States appealed, and Justice Kennedy delivered the unanimous opinion reversing that decision.

The Court began its analysis with a look at the relevant statutory text defining wages under FICA. Justice Kennedy noted that Congress chose to define wages broadly. Specifically, 26 U.S.C. § 3121(a) defines wages as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” Section 3121(b) goes on to define the term employment to encompass “any service, of whatever nature, performed ... by an employee for the person employing him.” Taking a “plain meaning” approach, the Court concluded that severance payments, “like many other benefits employers offer employees above and beyond salary payments,” such as “health and retirement benefits, stock options, or merit-based bonuses,” constituted “remuneration for employment.”

The Court then turned its attention to the appellate court’s holding. In reaching its decision, the 6th Circuit did not rely on FICA’s definition of wages, but instead looked to § 3402(o) of the IRS code, which governs income-tax withholding. Section 3402(o) provides, in relevant part, that “any supplemental unemployment compensation benefit paid to an individual … shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” (The United States and Quality Stores stipulated that the severance payments paid by Quality Stores constituted “supplemental unemployment compensation benefits,” or “SUB” payments.) From this “as if” language, the 6th Circuit inferred that such SUB payments were not actually wages for purposes of income-tax withholding, and that FICA necessarily encompassed the same definition of wages as that for income-tax withholding. The Supreme Court rejected this interpretation as unpersuasive. First, the Court concluded that Congress, in stating that all SUB payments should be treated “as if” they were wages, did mean to suggest that all SUB payments were not wages. Second, the Court disagreed that the heading of § 3402(o), which referred to “certain payments other than wages,” was somehow a pronouncement that all payments enumerated within § 3402(o) are not “wages.” Instead, the Court stated that the heading “[fell] short of a declaration that all the payments listed in Section 3402(o) are not wages.”

Finally, the Court conducted an in-depth examination of the regulatory history of SUB payments to further illustrate why the 6th Circuit had erred in its interpretation of § 3402(o). The Court pointed out that § 3402(o) had been enacted to address a specific withholding problem that arose among SUB plans in the 1950s. American employers agreed to fund trusts that would provide SUB payments to terminated employees, but in some states, the receipt of wages from a former employer rendered the employee ineligible for state unemployment benefits, which undercut the purpose of the plans. To address this problem, the IRS promulgated a series of Revenue Rulings that took the position that SUB payments — specifically those tied to eligibility for state unemployment compensation — are not wages under FICA. Given the regulatory history behind the enactment of § 3402(o), the Court concluded that this section had no bearing on FICA’s definition of wages. Thus, severance payments not tied to state unemployment compensation are taxable wages under FICA.

In the end, the Quality Stores decision simply preserves what most had considered the status quo — that is, severance payments will continue to be taxable wages, and will be subject to treatment as such under FICA.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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