In United States vs. Quality Stores, Inc., the U.S. Supreme Court confirmed the IRS’s position that severance payments generally fall within the scope of “wages” subject to Social Security and Medicare taxes on employers and employees under the Federal Insurance Contributions Act (“FICA taxes”). The March 25, 2014 ruling dashed the hopes of hundreds of companies that made protective refund claims for FICA taxes paid on severance amounts after the Sixth Circuit Court of Appeals upheld Quality Stores’ contention that the severance payments it made to thousands of its employees in connection with the company’s bankruptcy were exempt from FICA. Notably, however, the exemption from FICA taxation for certain severance programs tied to state unemployment insurance benefits (which were not at issue in Quality Stores) remains intact.
FICA’s Definition(s) of “Wages”
FICA taxes apply to wages paid by an employer or received by an employee “with respect to employment,” and FICA’s definition of “wages” in the Internal Revenue Code of 1986, as amended (the “Code”) includes “any remuneration for employment,” subject to certain enumerated exceptions. In 1939, Congress actually created an exception from the then-applicable statutory definition for “dismissal payments which the employer is not legally required to make,” but that exception was repealed in 1950. The Supreme Court’s ruling relies in part on FICA’s broad definition and takes note of Congress’ treatment of severance type payments as an explicit exception in the past. Though the result seems straightforward, Quality Stores pointed to arguably conflicting language in the Code regarding wage withholding.
“Wages” for Withholding Purposes
Code Section 3402(o) states that, for purposes of employer withholding on wages for federal income tax, “any supplemental unemployment compensation benefit1 paid to an individual … shall be treated as if it were a payment of wages by an employer to an employee for a payroll period” (emphasis added). Quality Stores argued that since severance payments are to be treated as if they were wages, they must not actually be wages for purposes of withholding. Further, existing precedent holds that the definition of “wages” applicable to withholding requirements should be construed the same as the FICA definition whenever possible. Therefore, Quality Stores reasoned, if severance payments are not wages for income tax withholding, then they should not be wages subject to FICA tax. But the Supreme Court rejected the premise that the “as if it were” phrasing precluded severance payments from being wages. The language is consistent with the idea that most severance payments are considered wages (in accordance with the broad FICA and withholding definitions), but some types of severance are not. As the U.S. Court of Appeals Federal Circuit Court stated in CSX Corp. v. United States, another case on severance taxation, “the statement that all men shall be treated as if they were six feet tall does not imply that no men are six feet tall.”
Section 3402(o)’s legislative history explains what types of severance may not be considered “wages.” Starting in the 1950s, certain employers established severance programs designed to work in conjunction with state unemployment benefits so that employees would continue to receive a certain level of income for a period of time after a qualifying termination of employment (e.g., due to a plant shutdown). The intention was for payments made under these plans (so-called “SUB pay”) to supplement the unemployment insurance benefits the former employee would receive. However, certain state laws made individuals who are receiving wages ineligible for unemployment benefits, which would undermine the intention of the plans if SUB pay were to be considered wages. Because these state laws generally followed federal tax treatment for determining what constitutes “wages,” the IRS issued a number of Revenue Rulings finding that severance benefits in the form of payments designed to supplement state unemployment benefits are not “wages” within the meaning of the FICA and withholding definitions. Although SUB pay was therefore originally exempt from withholding, it was still taxable income, and individuals receiving SUB pay could sustain large tax burdens when filing their taxes for the year. Thus, Congress passed the legislation resulting in Section 3402(o), which requires that all severance payments be treated as “wages,” whether or not the IRS deems such payments to fall within the applicable definitions.
NOTE: Quality Stores related to a reduction in force in connection with the company’s bankruptcy. There is no question that severance payments made in connection with individual employee terminations are “wages” subject to FICA tax
The Future of SUB Pay Plans
Quality Stores did not involve a SUB pay plan related to state unemployment benefits, and the Supreme Court holding does not affect the IRS Revenue Rulings establishing the exemption from FICA taxes (and taxes under the Federal Unemployment Tax Act (“FUTA”)) for such SUB pay plans. There is an open question as to whether the IRS has the authority under the applicable statutes to provide for these exemptions. Nevertheless, for the time being, properly structured SUB pay plans offer employers an opportunity to provide post-employment protection to employees in a tax efficient manner.
Certain criteria have developed for SUB pay plan benefits to qualify for the IRS’s “administrative exemption” from FICA and FUTA taxes. A 1956 IRS Revenue Ruling established the guiding principle: the payments must be designed to supplement the receipt of state unemployment compensation and actually be tied to the receipt of state unemployment benefits. Hallmarks of a qualifying SUB pay plan include: (1) eligibility for benefits is limited to individuals whose employment termination is involuntary (such as a layoff ); (2) entitlement to SUB pay, and the continuation of payments under the plan, are linked to ongoing eligibility for state unemployment benefits (although certain exceptions have been recognized); and (3) benefits cannot be attributable to the rendering of particular services, but the level of benefits may be based in part on the employee’s seniority. Lump sum payments, however, cannot qualify as SUB pay because the amount of the benefit received is not linked to the length of the individual’s unemployment.
Ultimately, there is no bright-line test for what qualifies as a SUB pay plan exempt from FICA, but it is clear that the more a plan varies from the prototypical arrangements previously approved by the IRS, the greater the risk that the plan payments could be treated as regular wages subject to FICA and FUTA taxes. ¢