Volume 37 | Issue 54 | April 28, 2014
Supreme Court rules nonqualifying SUB payments are
taxable FICA wages
The Supreme Court recently held that nonqualifying supplemental unemployment benefit
payments, which are made to involuntarily terminated workers but are not linked to the receipt of
state unemployment benefits, are taxable wages for FICA purposes. The decision resolved a
split in the circuit courts of appeal on this issue, and will disappoint thousands of employers who
had filed for FICA tax refunds in connection with similar payments. The Supreme Court did not
disturb, however, the IRS’ longstanding position that qualifying SUB payments tied to the receipt
of state unemployment benefits are exempt from FICA tax.
Background
Employers must withhold both FICA tax, the payroll tax that funds Social Security
and Medicare, along with federal income tax from wages paid to employees for
services performed. FICA defines the term “wages” as “all remuneration for
employment,” unless the remuneration is specifically excluded.
The Code provides that severance benefits meeting the Code definition of
supplemental unemployment benefit (SUB) payments are treated “as if” they were a
payment of wages for income tax withholding purposes. For this purpose, SUB
payments are defined as those paid under an employer plan to an employee who
has been involuntarily separated from employment as a result of a reduction in
force, discontinuance of a plan or operation, or similar conditions.
This “as if” Code language has led some taxpayers to argue that, although federal income tax withholding is
required on SUB payments as defined in the Code, FICA tax withholding is not required because these payments
are not actually wages. Rather, they are simply treated “as if” they are wages for income tax (but not FICA tax)
withholding purposes. The IRS rejects this interpretation, maintaining instead that these types of severance
payments are “wages” subject to FICA tax unless they meet the much stricter qualifying SUB payment definition (in
Revenue Ruling 90-72 and its predecessor, Revenue Ruling 56-249). Under the stricter definition, the payments
must be specifically linked to state unemployment benefits — and thereby made over a period of time, and not in a
lump sum, while the recipient remains eligible for state unemployment benefits.
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Volume 37 | Issue 54 | April 28, 2014
In a 2008 decision, the US Court of Appeals for the Federal Circuit upheld the IRS’ interpretation. However, in
2012, the US Court of Appeals for the Sixth Circuit in United States v. Quality Stores, Inc. accepted the taxpayer’s
position, holding that SUB payments of any type are not taxable as wages under FICA — and creating a split in the
circuit courts on this issue. Following the Sixth Circuit’s denial of the government’s petition for a rehearing (see our
January 24, 2013 For Your Information), the government appealed this decision, and the Supreme Court agreed to
hear the case.
Supreme Court decision
On March 25, 2014, the Supreme Court reversed the Sixth Circuit’s decision in Quality Stores, ruling that SUB
payments not linked to state unemployment benefits are taxable wages for FICA purposes.
In this case, the employer had terminated thousands of employees before and during Chapter 11 bankruptcy
proceedings. The terminated employees received severance payments that were not linked to state unemployment
compensation. The employer reported these payments as wages on employees’ W-2 tax forms, paid the
employer’s share of and withheld the employees’ share of FICA taxes. Later, though, the employer filed for a refund
of $1,000,125 in FICA taxes, and initiated a proceeding in the bankruptcy court to seek the refund. This proceeding
ultimately resulted in the Sixth Circuit’s decision that the severance payments are not “wages” under FICA.
The Supreme Court rejected the Sixth Circuit’s approach, first holding that FICA’s definition of “wages” as
“remuneration for employment” includes severance payments. In so finding, the court noted that severance
payments often vary — as they did in this case — according to the job function and seniority of the terminated
employee, and, in that sense, are similar to many other benefits employers offer above and beyond a salary. The
Court also highlighted the Code’s specific exemption from taxable wages for severance payments made “because
of . . . retirement for disability,” remarking that this exemption would be unnecessary if severance payments
generally did not fall within the definition of FICA wages.
The Court further rejected the position, adopted by the Sixth Circuit, that the Code provision requiring that SUB
payments of any type be treated “as if” they were payment of wages excludes those payments from the meaning of
“wages” for FICA tax purposes. Delving into legislative history, the Court noted that this Code provision was crafted
in this way to subject SUB payments to income tax withholding without designating such payments as “wages”
because some states only provided unemployment benefits if terminated employees were not earning wages from
their employers. Nevertheless, Congress wanted to impose a withholding tax on these payments so that terminated
employees would not face large tax bills at the end of the year. The “as if” language, the Court determined, simply
solved this particular income tax withholding problem and does not affect the status of nonqualifying SUB payments
for FICA taxation.
Finally, the Court acknowledged that the IRS exempts from FICA taxation qualifying SUB payments that are linked
to the receipt of state unemployment benefits. But, since the IRS revenue rulings establishing this position were not
under review by the lower court in Quality Stores, the Supreme Court had no need to affirm or reject the IRS’
position.
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Volume 37 | Issue 54 | April 28, 2014
Next steps for employers
In the wake of the Quality Stores decision, employers must withhold FICA tax on all nonqualifying SUB payments.
The IRS will deny the application of any employer who, following the Sixth Circuit’s decision, sought a refund of
FICA taxes paid on severance benefits that are not specifically linked to state unemployment benefits. Over 2,400
of these claims have been filed with the IRS and were suspended while the Quality Stores case was pending.
However, employers need not withdraw or take any other action on these applications.
In closing
This decision has important implications for employers’ severance plan design. To make severance benefits more
valuable both from the employer and employee perspectives by freeing them from FICA taxation liability, employers
should consider converting severance plans to qualifying SUB plans that satisfy the IRS requirements for FICA
exemption. To achieve this goal, the SUB plan’s payment structure must be conditioned on eligibility for state
unemployment benefits, and must be paid in installments rather than in a lump sum.
Authors
Julia Zuckerman, JD
Mary Roth, JD, LLM
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