Latham & Watkins Benefits, Compensation & Employment Practice
March 28, 2014 | Number 1669
US Supreme Court: Severance Payments are “Wages” for
FICA Tax Purposes
Final ruling will likely influence IRS to deny $1 billion in FICA refund claims to employers
across the US.
On March 25, 2014, the US Supreme Court ruled in favor of the Internal Revenue Service (the IRS) in
United States v. Quality Stores, Inc., holding that, in most cases, severance payments should be treated
as taxable wages and, accordingly, are subject to Federal Insurance Contributions Act (FICA)
withholding.
Case Background
Quality Stores involuntarily terminated thousands of employees in connection with bankruptcy
proceedings and paid the employees severance based on job grade, management level and years of
service. To facilitate Quality Stores’ post-bankruptcy operations, one of the two termination plans utilized
in these layoffs required employees to continue to remain employed through a date determined by the
employer in order to receive the severance pay. Quality Stores initially treated the severance payments
as wages, withheld all applicable taxes, including FICA, and reported the payments on employees’ W-2
tax forms. Several years later, Quality Stores filed FICA tax refund claims with the IRS, relying on
language in Section 3402(o) of the Internal Revenue Code (the Code), which provides that a severance
payment “shall be treated as if it were a payment of wages” for purposes of income tax withholding. The
Sixth Circuit agreed with Quality Stores that the inclusion of “as if” in Section 3402(o) of the Code
demonstrated that the general Code definition of “wages” did not include severance payments and
therefore, similarly, the analogous definition of “wages” for FICA tax purposes also does not include
severance payments.
Supreme Court Reversal
The Supreme Court reversed this Sixth Circuit decision, broadly interpreting the FICA definition of
“wages” in Section 3121 of the Code to encompass any remuneration for employment (other than very
specific enumerated exceptions). The Supreme Court held that the variation in severance pay amounts —
which rewarded loyalty as they were based on position and seniority — supported the conclusion that the
Quality Stores severance payments were, in fact, remuneration for employment, akin to bonuses, stock
options or other benefits that employers provide to employees in addition to salary payments. The
Supreme Court further held that the “as if” language in Section 3402(o) of the Code was not a limitation
on the definition of “wages” for FICA purposes. The Court found that the statutory history of that Code
provision demonstrated that the severance payments would only have been exempt from FICA taxes if
they had been designed to supplement state unemployment benefits and were actually tied to such
benefits.
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Conclusion
In the wake of the Sixth Circuit’s holding in Quality Stores, employers filed an aggregate of over $1 billion
in FICA refund claims with the IRS. In light of the Supreme Court’s decision, the IRS will now likely deny
those claims.
Most employers have treated severance benefits as wages. Following this decision, they should continue
to do so, and should withhold FICA taxes from severance payments, unless the severance arrangements
are tied to the receipt of state unemployment benefits. Employers who have not treated severance
payments as wages subject to FICA tax withholding may now face penalties and/or interest. Such
employers should change their practices for future severance payments in light of the Quality Stores
decision.
If you have questions about this Client Alert, please contact one of the authors listed below or the Latham
lawyer with whom you normally consult:
John D. Shyer
[email protected]
+1.212.906.1270
New York
Rifka M. Singer
[email protected]
+1.212.906.4528
New York
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March 28, 2014 | Number 1669 | Page 2