The Supreme Court’s Recent Decision on the Taxation of Severance Payments
Today, we discuss taxes – specifically, the taxation of severance payments. It has long been recognized that severance payments are “income” to an employee, and that employers must withhold federal income taxes from the payments. Earlier this year, the Supreme Court made clear that severance payments also are “wages” subject to FICA taxes, and that an employer must withhold FICA taxes as well. The case, United States v. Quality Stores, 134 S. Ct. 1395 (2014), resolved a split among two federal appellate courts that had led many employers to seek a refund of the employer share of FICA taxes paid to the IRS on severance payments.
FICA is the federal payroll tax on wages that funds Social Security and Medicare. The tax is paid by both employers and employees. Each pays 7.65% on the first $106,800 of the employee’s annual wages and then 1.45% on amounts exceeding that threshold. Employees never see their share of the tax – employers are required to withhold and pay the employee’s share to the IRS.
In the 2008 case of CSX Corporation v. United States, 518 F.3d 1328, the Federal Circuit agreed with the IRS that a form of severance called supplemental unemployment compensation benefits (or SUB payments) falls within the broad definition of “wages” subject to FICA taxes. But several years later in Quality Stores, the Sixth Circuit reached the opposite conclusion, holding that SUB payments are not wages subject to FICA taxes. 693 F.3d 605 (2012). The court reasoned that because section 3402(o)(1) of the Internal Revenue Code states that SUB payments shall be treated “as if” they are wages for income-tax withholding, they are not in fact wages.
In a unanimous decision, the Supreme Court reversed the Sixth Circuit. The Court held that severance payments – it did not limit its decision to SUB payments – fall within FICA’s “broad definition” of wages as “all remuneration for employment,” observing that “severance payments are, of course, ‘remuneration,’ and common sense dictates that employees receive the payments ‘for employment.’” The Court also noted that a specific exemption under FICA for severance payments made because of retirement for disability “would be unnecessary were severance payments in general not within FICA’s definition of ‘wages.’”
The Supreme Court disagreed with the Sixth Circuit that section 3402(o)(1) provides a basis for not treating severance payments as wages, reasoning that section 3402(o)(1)’s direction that all severance payments be treated “as if” they were wages for income-tax withholding is “consistent with the proposition that at least some severance payments are wages.” The Court also pointed out that the definition of wages for income-tax withholding in section 3401(a) contains several exemptions, but none are for severance payments.
So, what are the implications of the Supreme Court’s decision in Quality Stores? First, employees will lose a percentage of their severance payments to FICA taxes and will want a larger payment to account for that loss. Second, employers will have to pay an additional amount to the IRS on top of what they already pay to the employee and will want a smaller severance payment to account for that cost. And third, employers have an additional administrative task. They have to withhold the employee’s share of the FICA tax and pay that amount to the IRS with the filing of an employment tax return (IRS Form 941).