In a case decided earlier this year, United States v. Quality Stores, Inc., the U.S. Supreme Court resolved a split among the circuits and held that severance payments that are not linked to the receipt of state unemployment benefits are "wages" subject to FICA withholding. This decision overturned the Court of Appeals for the Sixth Circuit which had concluded that the taxpayer, Quality Stores, Inc., was entitled to a refund of FICA taxes paid with respect to severance payments. While not a favorable decision for the taxpayer, it does offer employers some certainty that severance payments, not linked to the receipt of state unemployment benefits, are subject to FICA.
The taxpayer, Quality Stores, Inc., entered bankruptcy proceedings in 2001. Both before and after entering bankruptcy, the taxpayer terminated thousands of employees and paid them severance based on their level of seniority and the number of years worked. The severance payments were completely unrelated to the receipt of state unemployment compensation. Quality Stores, Inc. reported the payments as wages on forms W-2, paid over both the employer and employee share of FICA, and then filed claims for refund of FICA (for itself and on behalf of the employees).
The Supreme Court began its analysis by noting the broad definition of "wages" provided in the Internal Revenue Code for purposes of FICA withholding. FICA defines wages as all remuneration for employment, and the Court noted that "as a matter of plain meaning, severance payments made to terminated employees are 'remuneration for employment.'"
Having established the relatively clear statutory authority for including severance payments in the definition of taxable wages for purposes of FICA, the Court next went on to address the taxpayer's primary argument that, pursuant to I.R.C. § 3402(o), severance payments are not taxable wages for purposes of income tax withholding and, therefore, cannot be taxable wages for purposes of FICA taxation. In other words, the taxpayer maintained that I.R.C. § 3402(o) should be interpreted to mean that severance payments are not included in the definition of wages for income tax withholding purposes and, therefore, should also not be included in the similar definition of wages for FICA purposes.
The Supreme Court disagreed with the taxpayer's statutory interpretation and concluded, instead, that based on the legislative history and purposes behind the enactment of I.R.C. § 3402(o), it was incorrect for the taxpayer (as well as the Court of Appeals for the Sixth Circuit) to interpret the statute as providing the broad principle that severance payments are not included in the definition of taxable wages for purposes of FICA. Accordingly, the Court held that the severance payments fell under FICA's broad definition of taxable wages because they were made to employees terminated against their will, were based on seniority and time, and were not linked to state unemployment benefits.
Finally, note that the Supreme Court explicitly declined to discuss the question of whether the IRS's current position in Revenue Ruling 90-72 that severance payments tied to the receipt of state unemployment benefits are exempt from both income tax and FICA withholding is consistent with the broad definition of wages under FICA. It is this continuing complexity and exceptions to the rule that makes it vitally important for employers to discuss severance payment issues with competent legal counsel.
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