Supreme Court: Severance Payments are Subject to FICA

By Robert Projansky, Elizabeth Mills & Nathan Bentley

Last week, in a decision highly anticipated by employers, the U.S. Supreme Court held unanimously that certain severance payments paid to employees who were involuntarily terminated are taxable wages for purposes of the Federal Insurance Contributions Act (FICA).

The high court's holding in United States v. Quality Stores, Inc., et al. reversed a Sixth Circuit Court of Appeals' decision and was a blow to employers' hopes that the court would exempt severance payments from FICA and open the floodgates for refund claims, the backlog of which was estimated to be in excess of $1 billion.

The decision leaves open whether the Internal Revenue Service can and will adhere to its long-held position on supplemental unemployment plans that, unlike the plans at issue in the case, are not paid in a lump sum and are tied to eligibility for state unemployment benefits. The IRS position on these plans has been that payments thereunder are not FICA "wages." The decision specifically did not address such plans.

By way of background, Quality Stores Inc. made severance payments to employees who were involuntarily terminated as part of the company's Chapter 11 bankruptcy. The payments were made pursuant to two different plans that did not tie the payments to the receipt of state unemployment insurance. Quality Stores paid and withheld taxes required under FICA, but later sought a refund on behalf of itself and its employees, arguing the payments should not have been taxed as wages under FICA.

Quality Stores initiated proceedings after the IRS did not respond to the refund request. The District Court and Sixth Circuit found in favor of Quality Stores, holding the severance payments were not wages under FICA, but the Supreme Court disagreed.

FICA payroll taxes apply generally to wages, which is broadly defined under Internal Revenue Code Section 3121(a) as all remuneration for employment. The court determined that severance payments, although paid after the employment relationship ended, are made in consideration for employment and therefore fall within the definition.

In so holding, the court rejected Quality Stores' argument that Section 3402(o) of the Internal Revenue Code (which relates to income tax withholding) is a limitation on the meaning of "wages" for purposes of FICA. Quality Stores had generally argued that since Section 3402(o) states that supplemental unemployment benefits ("SUB payments") should be treated as if they were wages, this must mean that they are not, in fact, wages. The court, however, disagreed, noting that the language of Section 3402(o) is consistent with the government's position that some SUB payments are wages, whereas others are not.

The court cited the regulatory background against which Section 3402(o) was enacted as evidence of Congress' intention to cover both SUB payments tied to state unemployment benefits (which the IRS continues to believe are not wages subject to FICA) and those that are not (such as the severance payments at issue in the case). The court refused to address whether the IRS's position that SUB payments tied to state unemployment benefits are exempt from income tax withholding and FICA taxation is consistent with the definition of wages.

As noted above, a number of employers had already filed protective claims for prior tax years so that they might recover FICA taxes if the Supreme Court ruled in favor of Quality Stores. In addition, in anticipation of the pending decision, some employers were gearing up to file their protective claims for the 2010 tax year by April 15 of this year. The Supreme Court's decision now effectively bars those claims for severance payments not linked to state unemployment benefits.

Robert Projansky is a New York-based partner in management-side law firm Proskauer's Employee Benefits, Executive Compensation & ERISA Litigation Practice Center. Elizabeth Mills is a senior counsel in Proskauer's Chicago office, focused both on health care organizations and tax exemption issues for not-for-profit organizations. Nathan Bentley is a New York-based associate in Proskauer's Tax Department.