Severance Payments to Terminated Employees are Taxable Wages under FICA

The Supreme Court recently held that severance payments made to involuntarily terminated employees constituted “remuneration for employment,” for which taxes must be withheld and paid under the Federal Insurance Contributions Act (FICA). United States v. Quality Stores, Inc., No. 12-408, 2014 U.S. LEXIS 2213 (March 25, 2014). This decision reversed the Court of Appeals for the Sixth Circuit decision on which many employers had relied to file requests for FICA tax refunds on severance payments.

Quality Stores and its affiliates paid severance to employees who were involuntarily terminated as part of Quality Stores’ bankruptcy. Severance payments were made under two plans and were calculated based on each employee’s job grade and management level or length of service. Neither payment plan was tied to the receipt of state unemployment benefits. Quality Stores reported the severance payments as wages and paid and withheld the required FICA taxes. Later, Quality Stores filed a request for a refund with the IRS, arguing the severance payments should not have been taxed as wages. The IRS did not allow or deny the claim, and Quality Stores brought suit.

The Court of Appeals for the Sixth Circuit ruled in favor of Quality Stores. The court considered the payments to be equivalent to supplemental unemployment compensation benefits, which it found were not wages for purposes of FICA.

The Supreme Court reversed. The Court pointed to the broad nature of FICA’s definition of “wages,” which includes “all remuneration for employment,” and the fact that FICA defined the term “employment” to mean “any service of whatever nature, performed…by an employee for an employer.” Based on these definitions, the Court reasoned that severance payments are like many other benefits employers offer for their employees’ services beyond wages. The Court also observed that, by varying the payments to the employees based on their function and seniority, the severance payments confirmed the principle that “service” means not only work actually done, but the entire employer-employee relationship for which compensation is paid. Accordingly, the Court held that severance paid to involuntarily terminated employees, which was based on job seniority and time served and was not linked to the receipt of state unemployment compensation benefits, fit “well within the definition of wages.”

Given the Supreme Court decision, employers need to ensure they are treating severance payments to terminated employees as wages, meaning that they need to withhold and pay the appropriate FICA taxes. Moreover, although the Quality Stores case only dealt with involuntarily terminated employees, there is little doubt that it would apply equally well to employees who receive severance as part of a voluntary departure.