This morning, the Supreme Court of the United States held that severance payments are taxable under the Federal Insurance Contributions Act (FICA) when made to employees whose employment is involuntarily terminated. The Court reasoned that FICA’s definition of wages encompasses severance payments and that the severance at issue in this case, which was not linked to the receipt of state unemployment benefits, was not exempt from FICA tax. United States v. Quality Stores, Inc., No. 12-1408, Supreme Court of the United States (March 25, 2014).

Factual Background

In the midst of entering into bankruptcy, Quality Stores, Inc., a specialty retailer, closed several plants or operations and discharged thousands of employees. The company paid the discharged employees severance payments pursuant to two termination plans based on seniority, job grade, and management level (among other factors). Quality Stores reported the severance payments as wages on W–2 tax forms, paid its share of FICA taxes, and withheld the employees’ share of FICA taxes. The company later asked its former employees to allow it to file FICA tax refund claims for them. As a result, the company filed a refund claim in the amount of $1,000,125 in FICA taxes, which the Internal Revenue Service (IRS) neither allowed nor denied.

Quality Stores then initiated a proceeding seeking a refund of the amount in the bankruptcy court, which granted summary judgment in the company’s favor. On appeal, both the federal district court and the Sixth Circuit Court of Appeals ruled in favor of Quality Stores. The Sixth Circuit held that the severance payments were not subject to FICA taxes because they qualified as supplemental unemployment compensation benefits (SUBs) as defined by Internal Revenue Code (IRC) section 3402(o)(2)(A)—thereby creating a circuit split on the issue. The Supreme Court agreed to hear the case to decide whether severance payments made to employees whose employment is involuntarily terminated are taxable under FICA.

Legal Analysis

As an initial matter, Justice Kennedy, writing for a unanimous court (with Justice Kagan recused from the case), noted that FICA’s definition of wages includes the severance payments Quality Stores made to its employees. Under both FICA’s definition of “wages” (as “all remuneration for employment”) and the plain meaning of the terms, severance payments are wages.

Justice Kennedy, in analyzing the statutory text, noted that the fact that FICA exempts some termination-related payments from the definition of wages shows that the severance payments at issue were purposely not exempted. For example, the Court noted that section 3121(a)(13)(A) exempts severance payments made because of retirement for disability from taxable wages. Moreover, FICA includes “a lengthy list of specific exemptions from the definition of wages.” “The specificity of these exemptions,” the Court found, “reinforces the broad nature of FICA’s definition of wages.” The Court also took into account FICA’s statutory history noting that Congress amended the statute in 1939 to create an exception from “wages” for dismissal payments that employers are not required to make. However, in 1950, Congress repealed that exception, and according to the Court, “since that time, FICA has contained no exception for severance payments.”

The Court then addressed the question of whether IRC section 3402(o), which relates to income-tax withholding, limits the meaning of “wages” for FICA purposes. Quality Stores argued that because section 3402(o) treats SUBs as wages for purposes of income tax withholding, the definition of wages for income tax withholding does not cover severance. Quality Stores argued further, if the definition of wages for income tax withholding purposes does not cover severance, then severance is not covered by FICA’s similar definition of wages. Quality Stores’s argument and the Sixth Circuit’s decision was incorrect, Justice Kennedy ruled, in using section 3402(o) to conclude that severance payments are not included in the definition of wages for the purposes of income tax withholding and thus, are also not included in the definition of wages for FICA taxation purposes.

Justice Kennedy again relied on statutory interpretation to find that the IRC chapter on income tax withholding has a broad definition of “wages,” which, like FICA, specifically exempts some payments from its definition, but not severance pay. He also reasoned that the regulatory background of section 3402(o) shows that it was enacted to solve a problem with employee withholdings—namely the prospect that involuntarily discharged employees who received SUBs would owe large payments in taxes at the end of the year as a result of the IRS’s administrative exemption of those payments from withholding. Congress enacted section 3402(o), the Court found, to provide that “all severance payments—both SUBs as well as severance payments that the IRS considered wages—shall be ‘treated as if’ they were wages for purposes of income-tax withholding.” Because section 3402(o) covers more than just severance payments that were excluded from income-tax withholding, the Sixth Circuit’s and Quality Stores’s interpretation of the section “as standing for some broad definitional purpose” failed. Thus, the Court concluded that section 3402(o) “does not narrow the term ‘wages’ under FICA to exempt all severance payments” from FICA tax.

Before concluding, the Court also noted that the severance payments at issue in the case were not linked to the receipt of state unemployment benefits. As a result, the Court expressly declined to consider whether the IRS’s current administrative position that severance payments that are tied to the receipt of state unemployment benefits are exempt from FICA taxation is consistent with the broad definition of FICA wages.

Based on these considerations, the Court reversed the decision of the Sixth Circuit and held that the severance payments at issue in this case—which had been made to employees who were discharged against their will, varied based on job grade and seniority, and had not been linked to the receipt of state unemployment benefits—constituted taxable wages.

Practical Impact

According to Vicki M. Nielsen, of counsel in the Washington, D.C. office of Ogletree Deakins, “Although not unexpected, the Supreme Court’s holding that severance paid to involuntarily discharged employees is subject to FICA will be disappointing to the many employers that filed FICA-tax refunds following workforce reductions in response to changes in the economy over the last several years and to their discharged employees, who either participated in those refund claims or filed their own, and to future financially-strapped employers and discharged employees. On the other hand, the government will not be faced with paying out the over $1 billion dollars of FICA tax refunds relating to this issue. In addition, employers in all industries across the United States that implemented a SUB plan that links severance pay to the receipt of state unemployment benefits, in accordance with the IRS’s administrative rulings issued over the last half-century, are going to be relieved that the Supreme Court’s decision left the IRS’s rulings intact. Pursuant to the IRS’s current ruling position, severance paid pursuant to a SUB plan to involuntarily discharged employees that is linked to the receipt of unemployment benefits and that is not paid in a lump sum is FICA exempt.”


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