U.S. Supreme Court Upholds Long-Standing Tax Treatment of Severance Pay
The U.S. Supreme Court has held unanimously that severance compensation paid to involuntarily terminated employees is taxable wages subject to FICA (Social Security and Medicare) taxes, sustaining the long-standing position of the Internal Revenue Service, the U.S. Tax Court and several Federal Courts of Appeals. U.S. v. Quality Stores, Inc., et al., No. 12-1408 (Mar. 25, 2014). Justice Elena Kagan did not take part in the decision.
The Court rejected the holding of the Court of Appeals for the Sixth Circuit that FICA taxes did not apply to severance payments made directly in connection with a reduction in force or a discontinuance of a plant or operation. The Sixth Circuit holding directly conflicted with the ruling by the Court of Appeals for the Federal Circuit in CSX Corp. v. U.S., 518 F.3d 1328 (2008), that approved the IRS position set out in Revenue Ruling 90-72. The conflict was based on different readings of the Internal Revenue Code and Congressional intent. There was no way to reconcile the two decisions and the Supreme Court did not attempt to do so.
The Supreme Court – unsurprisingly, based on its own prior rulings – flatly confirmed that the FICA tax definition of wages includes severance payments regardless of the reason for an employee’s termination. The Court observed it had previously held the general definition of “wages” for purposes of FICA taxes and federal income tax withholding is intended to be identical (except as modified by the specific exclusions in the statutes). Rowan Cos. v. U.S., 452 U.S. 247 (1981). It noted that severance payments clearly are “wages” subject to federal income tax withholding and nothing in the FICA tax provisions of the Internal Revenue Code created a different definition for FICA tax purposes.
The IRS has ruled severance payments that are linked to state unemployment benefits would be treated as exempt from FICA taxes if all of the following conditions are met:
1. Benefits are paid only to unemployed former employees who were laid off by the employer;
2. Eligibility for benefits depends on meeting prescribed conditions after terminating employment;
3. The amount of weekly benefits payable is based on state unemployment benefits, other compensation allowable under state laws, and the amount of straight-time weekly pay;
4. The duration of benefits is affected by the fund level and the employee’s seniority;
5. The right to benefits does not accrue until a prescribed period after termination of employment;
6. The benefits are not attributable to the rendering of particular services; and
7. No employee has any right, title, or interest in the fund until he or she is qualified and eligible to receive benefits.
IRS further held that this exception does not apply to a benefit paid in a lump sum, which cannot be excluded from FICA tax wages. IRS Revenue Ruling 90-72. (This ruling was specifically upheld by the Court of Appeals for the Federal Circuit in CSX Corp.) However, employers generally have found that meeting the conditions for this exception is neither practical nor desirable.
Finally, even the Sixth Circuit had held that its ruling did not apply to settlement of employment claims, specifically citing its prior decision in Gerbec v. United States, 164 F.3d 1015 (6th Cir. 1999), which held that an award of lost back pay and future wages was subject to FICA taxes.