Certain Severance Payments May Constitute Taxable Income But Not Wages
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When employers pay severance, it is common to withhold both income tax and payroll taxes under the Federal Income Contribution Act (“FICA”).  It is equally common for employers to pay the employer’s share of the FICA tax attributable to the severance payment.  These are common practices because Revenue Rulings issued by the Internal Revenue service classify most severance payments as “wages,” thereby subjecting those payments to the FICA tax.

In US v. Quality Stores, Inc., 2012 U.S. App. LEXIS 18820; 2012 FED App. 0313P (6th Cir. September 7, 2012), the Sixth Circuit considered the validity of the IRS’s Revenue Rulings as applied to $1,000,125 in FICA taxes paid pursuant to two severance plans.  At issue was the concept of supplemental unemployment compensation benefits (“SUB payments”).  Quality Stores contended that the severance pay constituted SUB payments and that as such the payments were not wages.  As the Court of Appeals explained, “Congress has provided (in I.R.C. § 3402(o)(2)(A)) that a SUB payment is: (1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee’s gross income.”  It was undisputed that the severance pay at issue in Quality Stores constituted SUB payment, that those payments were part of the recipients’ “gross income,” and that the employer was required to withhold income taxes.  What was in controversy was whether the SUB payments constituted wages, requiring payments of FICA tax.  

In a previous ruling the Federal Circuit found that payments including SUB payments “to the various groups of employees who were accorded benefits in connection with CSX’s reduction in force were all ‘wages’ or ‘compensation’ as those terms are used in FICA . . . .” CSX Corp. v. United States, 518 F.3d 1328, 1352 (Fed. Cir. 2008).  Nevertheless, after carefully considering the statutory language and history the Sixth Circuit concluded that “the payments Quality Stores made to its employees pursuant to the [severance plans] qualify as SUB payments and are not “wages” for purposes of FICA taxation.”  The Court of Appeals declined to give deference to the IRS revenue rulings and private letter stating that “Congress, not the IRS, prescribes the tax laws . . . .” 

Of course, not all severance payments are SUB payments, and thus some severance pay would constitute wages even under Quality Stores.  Further, because there is now a split in the circuits on this issue, Quality Stores does not definitively resolve the issue.  Accordingly, an employer should consult tax counsel when evaluating whether a specific severance payment constitutes wages under Quality Stores.  Also, any employer which has made SUB payments from 2009 forward for which the statute of limitations remains open should consult with tax counsel about filing a protective claim for refund pending the ultimate resolution of the issue by the courts.


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