Employers offer severance payments to separating employees for numerous reasons, including rewarding long-time employees affected by a plant closure, to maintain goodwill, to secure a release and waiver of existing or potential claims, or to comply with company policies or agreements that require such payments.  But whether the severance is dictated by policy or an individually-negotiated benefit, one sticky issue that employers may neglect to address is whether severance payments are subject to FICA taxes. The U.S. Supreme Court recently settled that issue by confirming that severance payments made to employees terminated against their will are taxable wages under FICA.  United States v. Quality Stores, Inc.No. 12-1408, 572 U.S. ___ (2014).  The Supreme Court’s ruling was consistent with the longtime IRS historical position on this issue. 

Involuntary Terminations Due to Bankruptcy Triggered Severance Payments 

Quality Stores terminated thousands of employees in connection with its involuntary Chapter 11 bankruptcy filing in 2001.  The employees received severance payments under one of two plans, ranging from six to eighteen months of severance pay.  Initially, Quality Stores reported the severance payments as wages for FICA purposes on the Forms W-2 filed with the IRS and the employees.  Consistent with such reporting, Quality Stores paid the employer’s required share of FICA taxes and withheld the employees’ share of FICA taxes as well.  Quality Stores then decided to file FICA tax refund claims with the IRS, totaling over $1 million in paid FICA taxes.  The IRS neither allowed nor denied the refund claims, so Quality Stores sought a refund as part of its bankruptcy proceeding.  Both the District Court and the Sixth Circuit Court of Appeals concluded that severance payments were not “wages” under FICA, meaning Quality Stores and its affected employees were entitled to a refund of the FICA taxes paid.  

The Sixth Circuit’s decision, however, directly contradicted rulings by other Courts of Appeals, which concluded that at least some severance payments constitute “wages” for purposes of FICA taxes. The U.S. Supreme Court agreed to review the issue to resolve the split among the courts. 

FICA’s Broad Definition of Wages Includes Severance Payments 

FICA defines wages as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.”  Under the plain meaning of this definition, the Court found that severance payments made to terminated employees constitutes “remuneration for employment.”  The Court noted that severance payments are made to employees only, often will vary depending on length of service, and are made in consideration for past services in the course of employment.  

Looking at statutory history, the Court noted that in 1950, Congress repealed an exception from “wages” for “[d]ismissal payments which the employer is not legally required to make” from the Social Security Act and since that time, FICA has not excepted severance payments from the definition of “wages.”  Agreeing with the government’s position in the case, the Court ruled that severance payments are taxable wages for FICA purposes. 

Implications for Employers 

The Court’s ruling confirms that employers are obligated to pay their portion of FICA taxes and withhold the employees’ portion of FICA taxes from severance payments.  Depending on the amount of the severance at issue, this FICA obligation can greatly change the total payout amount for the employer.  It also can catch unknowing employees off guard if they are expecting to receive a higher severance payment without FICA taxes being withheld.  Employers should factor the FICA tax obligation into any severance offer to ensure that both the company and the separating employee understand the total amount that is at issue and the final amount that the employee will receive.  In addition, employers offering severance payments should review their policies and practices to ensure that proper tax payments are made.  

If employers identify past severance payments where no FICA taxes were paid or withheld, such employers should consult with their tax counsel to determine whether any corrective steps are required.  In general, the applicable statute of limitations for an employer’s payroll tax liability begins on April 15 of the year following the year in which wages are paid (when prior year payroll tax returns are “deemed” to be filed), and expires after three years.  For example, the applicable statute of limitations for payroll taxes owed for 2010 began on April 15, 2011 and expires on April 15, 2014.